There are two main types of interest rates: fixed and variable. In most cases, a fixed rate is ideal since it involves less financial risk to the borrower. Still, a variable interest rate can be beneficial in a few specific circumstances.
What is a variable interest rate?
A variable interest rate is a rate that can go up or down over time. Usually, the rate changes when there’s a shift in a certain market condition, like an interest rate hike from the Federal Reserve. If a change like this causes your interest rate to rise, your monthly debt payment will likely rise, too.
When shopping for a new loan, you may be able to choose fixed-rate financing—which means you’ll have a set interest rate for the duration of your payment—especially if your credit is in good condition. But the following products often have variable rates, regardless of your credit or other qualifications:
- Home Equity Lines of Credit (HELOCs)
- Adjustable-Rate Mortgages (ARMs)
- Credit cards
- Private student loans
Variable interest rates vs. fixed interest rates: What’s the difference?
If a loan has a fixed interest rate, the interest rate will stay the same over the life of the loan. That means, unlike with variable loan rates, you’ll know your set monthly payment toward principal and interest in advance, as well as the total amount of interest fees you’ll pay over the life of the loan.
Fixed interest rates are common for many financial products, including personal loans, mortgages and home equity loans (HELoans).
Other loans that combine both fixed and variable interest rates are called “hybrid” loans. With a hybrid loan, you could have a fixed interest rate for a certain period of time, and then switch to variable interest rates for the remainder of the loan.
For example, if you have a 5/1 ARM from the FHA, the interest rate will stay the same for the first five years of your loan payment and then change by as much as one percent each year thereafter.
There are also credit cards with promotional interest rates that only last a limited time. With one of these cards, you might be charged 0% APR on balance transfers or credit card purchases for a set period of time after opening the account—often 12 months or more—and then pay a variable interest rate after the introductory period ends.
How are variable interest rates determined?
The interest rates on variable-rate loans change according to a “benchmark” or “index” rate. If you have a loan or a credit card with a variable rate, it may be based on one of the following:
- London Interbank Offered Rate, or LIBOR (for financing received before Dec. 31, 2021)
- The Secured Overnight Financing Rate, or SOFR (for financing received after Dec. 31, 2021)
- Ameribor
- Wall Street Journal (WSJ) prime rate
In most cases, the rate you pay equals the benchmark rate plus a markup from the lender, also known as a “spread” or “margin.” Your markup often depends on your credit: the better your credit, the lower your markup and interest rate.
Variable interest rates also change periodically, depending on the terms of your loan. Some credit issuers change rates at the start of each billing cycle that follows a change in the prime rate, while others adjust quarterly. They may also have a cap on how much your rate can change each period or over the life of your loan.
Pros and cons of variable interest rates
Pros
- Initial APR may be lower than market rate
- Can save you money if you pay off the debt before rates adjust
- May be easier to qualify for than fixed rates
Cons
- Could have a higher risk of default than fixed rates
- Your interest charges will increase if rates go up
- Future payment amounts are unpredictable
Are variable interest rates right for you?
Variable-rate loans can be great cost-saving tools for certain borrowers. For example, someone who plans to “flip” a house could take out an ARM, renovate and sell the home, and then pay off the loan before the rate adjustment period starts.
For most borrowers, however, variable interest rates can tempt them to take on high-risk debt. So if you’re interested in taking on financing with a variable rate, be sure to do the math first. There’s a possibility of the rate going up more than once, so you’ll need to make sure you have breathing room in your budget to cover debt payments that increase at some point in the future.
Written by Sarah Brady
Sarah Brady is a financial writer and speaker who’s written for Forbes Advisor, Investopedia, Experian and more. She is also a former Housing Counselor (HUD) and Certified Credit Counselor (NFCC).
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