What Does Variable Rate Mean?
In financial terms, a variable rate simply means an interest rate that can change over the life of a loan. Most consumers encounter variable rates in one of two ways: either through an adjustable-rate mortgage (ARM), or variable-rate credit cards, both of whose interest rates can change according to a number of formulas. In the wake of the financial meltdown of 2008, adjustable-rate mortgages have become less common, but variable-rate credit cards are now more common.
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Adjustable-Rate Mortgages
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ARMs are mortgages with variable rates, and are structured so that their interest rate changes on a fixed schedule, such as every three months or six months. The change is calculated by pegging the ARM to a common financial benchmark, such as the London Interbank Offered Rate (LIBOR). As an example, an ARM might have a variable interest rate of LIBOR plus 3 percent. So if LIBOR happens to be 4 percent on the day the variable interest rate resets (changes), the new interest rate would be 7 percent.
ARMs Pro & Cons
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The main advantage of ARMs is that their interest rate can be low compared with a standard fixed-rate mortgage, if the benchmark index remains low. However, benchmark indexes can go up quickly and stay high, and that can cause sudden extra expense for the borrower. During the early- to mid-2000s, many ARMs structured to automatically reset higher after a period of years were made to borrowers who could not afford the reset rate, a fiasco that helped diminish the popularity of ARMs in more recent years.
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Variable Interest Rate Credit Cards
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The other kind of common variable interest rate is found on credit cards, where it is also known as a floating rate. It is also tied to a financial index, such as the Prime Rate, which is set indirectly by the Federal Reserve Bank of the United States. The exact relationship usually takes the form of "Index + 9.9 percent." Thus a 3 percent Prime Rate would mean that the credit card's interest rate would be 12.9 percent. Whenever the index moves, so does the interest rate on the credit card.
Variable Rate Credit Cards More Common Now
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Many more credit cards now feature variable rates than before, because credit card reform passed by the U.S. Congress. Effective in early 2010, it became more difficult for card issuers to change basic terms of the cards they issue, such as converting a fixed-rate card to a variable-rate one. So credit card companies converted a lot of fixed-rate cards to variable ones before the law took effect.
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