When it comes to figuring out if a particular loan could be a good fit for your financial situation, interest rates are an important consideration. After all, your interest rate is a key factor in the total cost of borrowing. There are two main types of interest rates: fixed and variable. Here we’ll take a closer look at variable interest rates, including how they differ from fixed rates and how they’re typically determined.
How are fixed and variable interest rates different?
If a loan has a fixed interest rate, the interest rate stays the same over the life of the loan. With a fixed rate, you’ll know in advance what your payment will be each month and the total amount of interest you’ll pay over the life of the loan. Personal loans through Prosper, for example, have fixed interest rates. Many other forms of financing, like auto loans and federal student loans, are commonly offered with fixed interest rates.
If a loan has a variable interest rate, the interest rate can change, meaning it can go up or down over time according to a benchmark rate (more on benchmark rates below). Home equity lines of credit (HELOCs), for example, generally have variable interest rates. Many credit cards and mortgages have variable rates, and it’s also common for private lenders to offer variable-rate student loans. Loans with variable rates are sometimes referred to as floating-rate loans.
It’s also possible to have a “hybrid” loan, which would have a fixed interest rate for a certain period of time then switch to variable interest rate.
How are variable interest rates determined?
The interest on a variable-rate loan changes according to what’s called a “benchmark” or “index” rate. Two common benchmarks for variable-rate loans in the U.S. are:
- The Wall Street Journal U.S. prime rate – the base rate on corporate loans posted by at least 70% of the 10 largest U.S. banks.
- London Interbank Offered Rate (LIBOR) – the average interest rate banks charge each other to borrow money.
In most cases, the interest rate you’ll pay equals the specified benchmark rate plus a markup determined by the lender, sometimes referred to as a “spread” or “margin.” Your markup often depends on the strength of your credit profile: stronger credit typically means you’ll be charged a lower spread, and therefore a lower interest rate.
As the benchmark rate goes up or down, so does the interest rate on your loan. Let’s say you have a loan with a variable interest rate that equals the Wall Street Journal U.S. prime rate + 3%. If the prime rate is 5%, your interest rate would be 8%. If the prime rate goes up to 6%, your interest rate would also increase, reaching 9%. Alternatively, if the prime rate declines to 4%, your interest rate would also fall, dropping to 7%.
How frequently your variable interest rate changes depends on the terms of your loan. For example, some credit card issuers change their interest rates at the start of the next billing cycle following a change in the prime rate. Other loans make interest rate adjustments on a quarterly basis. Be sure to read your loan agreement to see how your issuer sets and adjust rates.
What are the possible pros and cons?
It’s important to note that rising interest rates can meaningfully increase the cost of borrowing, and, with a variable-rate loan, it can be difficult to predict exactly what your interest rate will be in the future. Some variable-rate loans come with an interest rate cap (maximum) and floor (minimum), which can help when calculating how much you’ll potentially pay in interest over the life of a loan.
Returning to the example above, where your loan’s interest rate equals the prime rate + 3%, let’s say your lender has capped your interest rate at 14%. If the prime rate were to reach 12%, your interest rate would only increase to 14% (not 15%), thanks to the cap.
It’s also worth noting that a loan with a variable rate typically starts out at a lower rate than a similar loan with a fixed rate. If you choose the variable-rate option, it’s true that you’ll be taking on a certain level of risk that your rate could go up—but you’re also (potentially) starting off with a lower rate than you’d get with a fixed-rate loan. For some people, this is an important benefit. Before making a final choice, smart borrowers spend time crunching the numbers on potential interest payments and also thinking carefully about their comfort with possible rate increases.