What Are Some Risks of a Variable Rate Loan?

Many wonder whether variable loans are too good to be true.

Variable rate loans, sometimes referred to as adjustable rate loans relating to home mortgages, certainly have their share of risks. What is somewhat ironic is that many of the risks involved with these types of loans are also what make them appealing to borrowers. While the uses of variable rate loans are many -- auto, home and even secured and unsecured credit lines -- they all share similar risks.

Low Rates Now, High Rates Later

Lowering the initial payments required when borrowing, for any type of loan, allows many people access to funds they would not have otherwise qualified for. Since one of the attractive features for many variable rate loans are the lower initial interest rates, this often translates to more funds. However, if saving 1 or 1.5 percent now is the difference between qualifying and not qualifying for a loan, then there is a good chance that when rates rise, the higher payments will become burdensome, if not impossible to withstand.

Varying Adjustment Periods

Borrowing money to purchase a car using a variable rate loan is often an exciting time for an individual or family. Sometimes so much so that people fail to truly understand the terms of the loan. Some variable auto loans, for example, will adjust their rates monthly. This means that with every increase in rates, there will be a subsequent increase in payments required. What appeared to be a manageable monthly outlay a short while ago can very quickly become overwhelming.

Variable Rates Based on Different Indices

Understanding what index the variable rate is determined by and how many percentage points are added to it will help you to quantify risk. Many auto and home equity loans are based on the prime rate. The prime rate is the rate that banks charge their "best" customers and is generally about 3 percent above the overnight federal funds rate, the rate banks charge each other to borrow. What many variable lenders will do is offer a rate that is prime plus "n" amount of interest.

Worst-Case Scenario

Every bit as critical, if not more so, than knowing the index is knowing just how high your variable loan rate can go over the course of the loan term. Most variable lenders will "cap" the loan, often around 5 percent higher than the initial rate, over the life of the loan. When you start to do the math, you begin to realize how much that can impact monthly payment obligations. For example, if your initial rate for a variable rate auto loan is 6 percent with a payment of $250 per month, then imagine how high that payment goes if the annual rate reaches 11 percent.

References

• Western Federal Credit Union: The Risky Business of Variable Auto Loans
• The Street: Variable Rate Auto Loans Not Always Worth the Risk
• "The New York Times": More Transparency for Variable-Rate Loans