How Does a Variable Loan Work?
When borrowing money, one of the biggest decisions is whether to get a fixed or a variable interest rate. While a fixed-rate loan has the same interest rate for the entire repayment term, a variable-rate loan has an interest rate that fluctuates. Some of the most common types of variable-rate loans are mortgages, home equity lines of credit, auto loans and credit cards.
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Fluctuate with Index
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Rather than having a specific interest rate, a variable-rate loan has a margin tied to an index rate. The index rate might be the prime rate or other financial index. Index rates change regularly with market conditions. The margin is the amount the lender adds to the index rate when calculating your interest rate. For example, say you have a variable loan with an interest rate of prime plus 5 percent. If the prime rate is currently 3.25 percent, your interest rate is 8.25 percent. If the prime rate goes up to 4.5 percent, your interest rate will go up to 9.5 percent.
Adjustment Period
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Variable-rate loans do not always adjust every time the index rate adjusts. The loan contract will specify how frequently your interest rate can change. For example, if you have a 3-year adjustable-rate mortgage, every three years, your lender will check the index rate and adjust your interest rate for the next 3-year period accordingly. Some mortgages have a longer fixed period at the beginning and then adjust more frequently. For example, a 5/1 ARM has a fixed interest rate for the first five years and then adjusts every year thereafter.
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Interest Rate Caps
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Most lenders of variable-rate loans will set specific floor and ceiling caps beyond which your rate cannot extend. For example, your loan agreement might state that your interest rate cannot get lower than 4 percent or higher than 15 percent. If the index rate plus your margin is outside those boundaries, you will just pay the boundary rate. In addition, some loans limit how much the interest rate can change during each adjustment period. For example, your ARM interest rate might not be able to increase more than 2 percent each year.
Considerations
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Loans with variable interest rates have both benefits and drawbacks. One of the major benefits is that the interest rate you pay will drop if market conditions cause the index rate to decrease. If you are buying a house and plan to move within the first five years, getting an ARM can save money, because the rate you pay for the first three or five years is usually lower than the rate you would have on a fixed-rate mortgage. However, variable-rate loans can be risky, because your payments will increase if the index rate goes up. If you do not budget for these payments, you might end up not being able to afford them.
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