Variable Rate Loans
A type of loan where the interest rate changes according to changes in market interest rates
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What are Variable Rate Loans?
A variable rate loan is a type of loan where the interest changes according to changes in market interest rates. Unlike a fixed-rate loan, where borrowers pay a constant interest rate, a variable rate loan comprises varying monthly payments that change according to the market interest rate changes.
Usually, lenders follow a financial index such as the Federal lending rate or the London Interbank Offered Rate (LIBOR). If the specific index changes, the lender adjusts its interest rate to match the index. However, changes to the interest rate charged to the customer are not drastic but rather occur periodically according to the lender’s agreement.
Summary
- A variable rate loan is a type of loan where the interest rate changes with the changes in market interest rates.
- The variable interest rate is pegged on a reference or benchmark rate such as the federal fund rate or London Interbank Offered Rate (LIBOR) plus a margin/spread determined by the lender.
- Examples of variable rate loans include the variable mortgage rate and variable rate credit cards.
How Variable Rate Loans Work
The variable rate loan is pegged on a specific reference rate or benchmark index such as the London Interbank Offered Rate (LIBOR). The LIBOR is the interest rate at which banks borrow from each other. The rate is obtained by surveying banks and getting information on the interest rates that they pay when borrowing from peer institutions.
An alternative to LIBOR is the prime rate in a country. The prime rate is used as a reference rate for auto loans, mortgages, and credit cards. The rate is tied to the Federal Reserve funds rate, which is the interest rate charged for overnight borrowing to meet reserve funding requirements. The federal funds rate is regulated directly through the Federal Reserve’s policies.
The LIBOR and the prime rate of a country are used as the starting point for commercial lenders when setting their interest rates. Usually, lenders charge consumers a spread or margin over the selected benchmark rate to generate a profit. The margin charged to the consumer will depend on various factors such as duration of the loan, type of asset, and the consumer’s risk level (credit score and credit rating).
The benchmark plus the lender’s margin/spread add up to produce the actual interest rate charged to the consumer. For example, an auto loan may be priced at 6-month LIBOR + 3%. It means that the loan will use LIBOR as the benchmark rate and will change at the end of each six-month period. The 3% is the margin charged by the bank to the consumer.
Benefits of Variable Rate Loans
From the borrower’s perspective, a variable rate loan is beneficial because they are often subject to lower interest rates than fixed-rate loans. Most often, the interest rate tends to be lower at the beginning, and it may adjust in the course of the loan term. However, during periods of constantly fluctuating interest rates, a fixed-rate loan tends to be more attractive than a variable loan. In such cases, fixed-rate loans come with an interest rate that remains unchanged during the duration of the loan.
From the lender’s perspective, a variable rate loan offers greater value compared to a fixed-rate loan. Lenders can adjust the interest rate upwards to reflect market changes, while the interest charged on a fixed rate interest remains fixed regardless of the changes in the market.
What is a Variable Rate Mortgage?
A variable rate mortgage is a home loan where the interest rate is adjusted periodically to reflect changes in the benchmark interest rate. Mortgage lenders can offer a variable interest on the home loan for the entire term of the loan or offer an adjustable-rate mortgage that combines both fixed and variable interest rates. A variable rate mortgage is adjusted at a rate that is above the reference or benchmark rate.
Borrowers prefer variable loans when they expect interest rates to fall in the future. They can benefit from lower interest rates when market interest rates decline. On the other hand, where the loan agreement provides a cap on the variable rate, the borrowers are protected from rising interest rates. It means that there is a maximum limit on how much the borrower can be charged regardless of the benchmark interest rate.
How a Variable Rate Mortgage is Structured
The variable rate for a mortgage is structured in a way that it includes an indexed rate and a variable rate margin. High-quality borrowers may qualify for just the indexed rate, which is pegged on the lender’s prime rate or LIBOR. The borrowers are charged an interest rate on the mortgage that fluctuates with changes in the market rates.
The loan takes two forms. First, borrowers can be charged a variable interest rate throughout the entire term of the loan. The interest rate, in this case, will be pegged on the indexed rate plus a spread/margin determined by the lender. Apart from the full-term variable rate loan, the variable interest rate can be part of a hybrid loan.
An example is an adjustable-rate mortgage that combines both fixed and variable interest rates during the term of the loan. The 5/1 adjustable-rate mortgage requires borrowers to pay a fixed interest rate for the first five years of the loan term and a variable interest rate that would reset each year based on the indexed rate at the reset date.
Additional Resources
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