Interest rates are a fundamental component of the financial landscape. It affects everything from loans and mortgages to investment and savings accounts. Understanding the concept of variable interest rates is crucial for individuals, businesses, and investors, as it can significantly impact on their financial decisions and outcomes. Follow along to learn more about what variable interest rates are, their implications, and their pros and cons.
Definition Of A Variable Interest Rate
A variable interest rate is a type of interest rate that is not fixed and can vary over the life of a loan or investment. It is usually tied to a reference rate like the prime market rate or an index like LIBOR. As the reference rate changes, the variable interest rate adjusts accordingly. This means that the cost of borrowing or the return on investment can change, potentially impacting monthly payments or overall earnings.
Variable Interest Vs Fixed Interest Rates
Variable and fixed interest rates are two different approaches to charging interest on loans or investments. The main difference lies in determining the interest rate and whether it remains constant or changes over time. Here’s a detailed explanation of each type:
1. Fixed Interest Rates
A fixed interest rate remains unchanged for a specific period, typically for the entire duration of the loan or investment.
The key features of fixed interest rates include:
- Consistency: Fixed interest rates give borrowers and investors predictable and consistent payment amounts, making financial planning and budgeting more convenient.
- Protection Against Market Fluctuations: Fixed interest rates protect borrowers and investors from potential market rate increases, allowing them to maintain the initial agreed-upon rate. This offers advantages in a rising rate environment.
- Potentially Higher Initial Rates: Lenders or investors may charge higher initial rates for fixed-rate loans or investments to account for the risk of a decrease in future rates. Fixed rates offer a guarantee, potentially causing them to miss out on higher returns if rates decline.
- Limited Flexibility: Fixed interest rates lack flexibility as they remain constant despite changes in market rates. Borrowers or investors cannot take advantage of rate decreases during the agreed-upon period.
2. Variable Interest Rates
A variable interest rate, or an adjustable interest rate, can change over time based on fluctuations in an underlying benchmark rate or index.
The key features of variable interest rates are as follows:
- Adjustments Based On Market Conditions: Variable interest rates are linked to external benchmarks like the prime rate or LIBOR, leading to fluctuations in rates and payment amounts for borrowers or investors. Changes in the benchmark rates directly impact the variable interest rates.
- Potential For Savings Or Increased Returns: If market interest rates decrease, borrowers with variable rates may benefit from lower interest payments. Similarly, investors with variable-rate investments may enjoy higher returns when rates rise.
- Exposure To Market Risks: Variable interest rates carry the risk of rising rates, which can lead to increased monthly payments or returns, affecting financial planning for borrowers or investors.
- Flexibility: Variable interest rates offer more flexibility compared to fixed rates. Borrowers or investors can take advantage of falling rates by paying less interest or seeking better investment opportunities if rates rise.
Fixed and Variable interest rates can benefit investors and borrowers in different ways. This is why it is important to consider your financial goals and risk tolerance before making any financial decisions.
Variable Interest Rate Pros and Cons
| Pros: | Cons: |
|---|---|
| Rates will sometimes be lower than with fixed interest rates | Very unpredictable, making it difficult for borrowers to plan their financial futures |
| When rates decrease, borrowers will save money | When interest rates rise, borrowers will pay more way more interest |
| Option to make additional payments when the rates are low | Fluctuating interest rates can make it challenging for borrowers to establish a consistent budget, as monthly payments can change. |
| Offsets risk so those with bad credit are more likely to get credit approvals |
Why Do Variable APRs Change?
The variability of APRs is based on benchmark rates, which have the potential to fluctuate over time. The prime rate and the Secured Overnight Financing Rate (SOFR) are the most commonly used benchmark rates.
1. Prime Rate
The prime rate, used by financial institutions to determine credit card and line of credit APRs, is influenced by the federal funds rate. The federal funds rate is the interest rate that banks charge each other for overnight reserve borrowing.
2. SOFR
The SOFR represents the overnight interest rate at which banks engage in borrowing or lending transactions with one another. The SOFR distinguishes itself by incorporating Treasury bond purchase agreements, leveraging bonds as collateral. This special interest rate is frequently employed in adjustable-rate mortgages and specific private student loans.
The Federal Reserve determines the federal funds rate, which affects the prime rate. The Federal Open Market Committee (FOMC) adjusts the rate in response to market conditions. It is raised during inflationary periods to limit cash access and lowered during economic distress to promote borrowing.
On the other hand, the SOFR is a daily fluctuating rate based on Treasury repurchase transactions. Some loans have variable rates that may change every six to 12 months, with limits on rate fluctuations. Credit card APRs often change shortly after changes to the prime rate.
What Can You Do If Your Variable Interest Rate Changes?
Although adjustments to a variable APR are unavoidable, it’s essential to remember that you still have options. For example, you could pay off your balance, get a new card, or even refinance.
Here are the top things you can do if your variable interest rate increases:
1. Get A New Credit Card
You can explore alternative cards with lower APRs if your credit has improved. However, remember that if your variable APR has increased due to market rate changes, the same applies to any other card you consider.
2. Pay Off Your Balance
Paying your credit card balance in full each month is ideal. If you haven’t been doing so, prioritize it now to avoid higher interest costs. This principle also applies to personal loans or home equity lines of credit.
3. Refinance Your Loan
Consider refinancing to a fixed-rate loan for variable interest rate loans like student loans or adjustable-rate mortgages if your APR increases. While the new fixed rate may be slightly higher, it will prevent your interest costs and monthly payments from rising in the future.
Bottom Line
Understanding how interest works, including variable interest rates, is crucial for financial savviness. Variable interest rates can change over time, impacting the cost of borrowing and investment returns. By grasping these rates, individuals can make informed decisions about loans, mortgages, credit cards, and investments. Being aware of the risks and rewards associated with variable interest rates enables better adaptation to changing financial landscapes, empowering individuals to make sound financial choices.
Frequently Asked Questions (FAQs)
Is a variable interest rate good?
Generally speaking, variable interest rates are not a good thing. While you can get a lower interest rate with variable interest at times, they’re unstable and make it difficult to create a solid financial plan. After all, you can’t estimate your costs when you don’t know how much you will be charged in interest. So a variable interest rate can sometimes have lower interest rates than a fixed interest rate, it can also have higher interest rates.
Is 24.99% variable APR good?
We’ll be honest with you, a 24.99 percent variable APR is not good. Well, it is good for the lender who is earning the interest rate, but it’s not good for anyone to pay 24.99 percent interest. This figure is becoming increasingly common–especially on credit cards and personal loans–for those with poor credit. However, it is a very high-interest rate and one that is likely to keep set you back further from financial freedom.
How can I get a better interest rate?
If you’ve been approved for a loan or credit card, but aren’t thrilled about the rate you can contact the lender and ask for a lower interest rate. However, a major factor in getting better interest rates is to have a great credit score. Learn more about how to improve your credit score in just 21 days.