Define Variable Interest Rate
When a borrower seeks to obtain money from a bank or lending institution, he must pay that lending institution interest on the money that he wishes to borrow. The amount of money that he will pay is called interest. The higher the interest rate, the more money the borrower must pay the lending institution over the life of the loan. Certain interest payments are fixed, meaning that the rate never changes over the life of the loan, while others are variable.
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Definition
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A variable interest rate is an interest rate that changes because it is based on another interest rate index. For instance, say a bank is borrowing money at 2 percent, and has agreed to lend money to you at 4 percentage points over what they are paying. If the bank suddenly has to borrow money at 3 percent, your rate will be raised to 7 percent. In this way, it is variable.
Mortgages
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Many people obtain variable interest rate mortgages for their home loans. (These are also sometimes referred to as Adjustable Rate Mortgages, or ARMs.) During these loans, the interest rate is usually fixed for a certain period of time. The loan then adjusts, usually to a higher amount, for the life of the loan. Variable rate mortgages are attractive for people who are trying to keep their payments low at the outset of their loan. This can prove effective if the borrowers plan to move, or refinance after the initial fixed term of the loan is over.
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Credit Card
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Many credit cards are variable rate credit cards. These credit cards are based on the prime rate, which fluctuates as the federal reserve raises or lowers the Federal Funds Rate. The Federal Funds Rate is the amount of interest that the government charges for short-term loans. The credit card companies then impose a margin, which is a fixed rate, on top of the prime rate to come up with the variable interest rate they are charging you. For instance, if the prime lending rate is at 2 percent, and the credit card company has a fixed margin rate of 13 percent, then your credit card interest rate would be 15 percent. If the prime rate is raised by 1 percent, so too will your credit card interest rate.
Student Loans
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Student loan products are offered by Sallie Mae. Sallie Mae provides federal and private loans for students seeking to obtain both undergraduate and graduate degrees at colleges and universities across the nation. Some of its loan products are variable interest rate loans based on the LIBOR Index. The LIBOR Index stands for the London InterBank Offered Rate. These student loans work in the same manner as variable rate credit card rates, in which Sallie Mae charges a fixed rate above the LIBOR rate over the life of the student loan.
Advantages and Disadvantages
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When the base indexes associated with variable rates are low, it can seem quite attractive to jump into a variable rate loan. However, if those index rates rise, you can suddenly be caught off-guard as the interest rate you are paying the lending institution suddenly rises as well. While a point or two on a small credit card balance will not seem like a major adjustment, a point on a mortgage can raise your mortgage significantly. If you obtain variable interest loans and mortgages, seek to obtain one with a cap. A cap will prevent the interest rate from rising above a certain amount during the course of the loan.
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References
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