What Are Some Risks of a Variable Rate Loan?

When you're shopping for a mortgage, your loan options may seem endless. One of the many mortgage products you can apply for is a variable rate loan – often referred to as an adjustable rate loan. The loan's initial interest rate is often significantly lower than the rate banks offer on fixed rate loans. The loan's interest charges remain the same during the initial rate period. Once that period expires, however, your interest rate fluctuates. Although variable rate loans are generally mortgages, you can obtain a variable interest rate on student loans, personal loans and auto loans -- with similar risks and benefits.

One major drawback of variable rate loans is the prospect of higher payments. Your loan's interest rate is tied to a financial index, which fluctuates periodically. If the index rises before your loan adjusts, your interest rate will also rise, which can result in significantly higher loan payments. You can reduce your risk by asking your lender which category index the company uses when calculating interest rates. If the lender uses an index based on rate averages, your payments will rise or fall more slowly. If your lender ties your interest rate to a spot index, your payments could skyrocket without warning.

The low initial payments you enjoy with a variable rate loan may make the loan itself seem ideal. Unfortunately, when you make small payments on a big loan, you could be in danger of negative amortization, which occurs when you owe more on an asset than that asset is actually worth. Some lenders place payment caps on variable rate loan payments. If your loan has a payment cap, your payments won't rise beyond a certain limit -- regardless of how high the index rises. This payment cap, however, could allow your interest charges to climb faster than you can pay them down. This leaves you facing negative amortization and makes it almost impossible to sell or refinance the asset.

The higher your interest rate climbs, the more profit your lender makes. This also means that you'll have to apply a greater portion of your income to your loan. Refinancing or selling the asset could help you shrug off the burden of a steadily climbing rate, but your lender can toss a major obstacle into your path via a prepayment penalty. If your variable rate loan contains a prepayment penalty, you can't pay off the loan early without paying a considerable fee to your lender. In some cases, you can't even pay off a portion of your loan without incurring a penalty. A loan's prepayment penalty may expire after several years or may last the life of the loan.

Because the interest rates on variable rate loans are so unpredictable, borrowers who opt for these loans run a higher risk of default. Once you default on your loan, your lender has the option to seize any collateral attached to the loan. The consequences, however, go far beyond property loss. Not only do you face credit damage when you default on a loan, the lender may not be able to sell the collateral for enough money to cover your loan balance. Should this occur, you are responsible for paying the difference, and your lender can sue you to ensure that you do just that. After suing you, your lender can generally attach liens to your other assets, seize your bank accounts or garnish your wages.