Variable Interest Rate
A variable interest rate is an interest rate that can change over time based on underlying benchmarks or market conditions. Unlike a fixed interest rate, which remains constant throughout the loan term, a variable rate fluctuates. Variable rates are often tied to economic indicators, such as the U.S. federal funds rate or the LIBOR (London Interbank Offered Rate), among others.
How it Works:
A variable interest rate is usually structured as follows:
Variable Interest Rate = Benchmark Rate + Spread
- Benchmark Rate: This is a base interest rate that is determined by market conditions. It’s usually a well-known, published rate like the LIBOR or the federal funds rate.
- Spread: This is a fixed percentage that is added to the benchmark rate. The spread compensates the lender for the risk associated with lending money.
For example, if the benchmark rate is 1% and the spread is 2%, then the variable interest rate would be 3%. If the benchmark rate changes to 1.5%, the variable interest rate would adjust to 3.5%.
Advantages:
- Lower Initial Rates: Variable rates are often lower than fixed rates at the outset, making them attractive for short-term borrowing.
- Benefit from Falling Rates: If interest rates fall, borrowers with variable rate loans can benefit from lower repayment costs.
Disadvantages:
- Rate Risk: Borrowers are exposed to the risk of rising interest rates, which can increase their repayment costs.
- Budgeting Difficulty: Fluctuating rates can make it hard to budget for loan payments, especially for long-term loans like mortgages.
Common Uses:
Variable interest rates are commonly used in:
- Adjustable-rate mortgages (ARMs)
- Student loans
- Personal lines of credit
- Business loans
Example of Variable Interest Rate
Let’s go through an example involving a variable interest rate loan.
Example: Variable Interest Rate Student Loan
Imagine you’re a student who has taken out a $20,000 student loan to pay for college expenses. The loan has a variable interest rate tied to the LIBOR plus a spread. Here’s how it’s structured:
- Initial LIBOR Rate: 1%
- Spread: 3%
- Initial Variable Interest Rate: 1% (LIBOR) +3% (Spread) =41% (LIBOR) +3% (Spread) =4
Year 1:
- Loan Amount: $20,000
- Interest Rate: 4% (1% LIBOR + 3% Spread)
For simplicity, let’s say you’re only interested in calculating the interest for one year.
- Interest for Year 1: $20,000 x 0.04 = $800
Year 2:
In the second year, assume the LIBOR rate increases to 1.5%.
- New Variable Interest Rate: 1.5% (LIBOR) +3% (Spread) =4.51.5% (LIBOR) +3% (Spread) =4.5
- Interest for Year 2: $20,000 x 0.045 = $900
Year 3:
In the third year, the LIBOR rate falls to 0.8%.
- New Variable Interest Rate: 0.8% (LIBOR) +3% (Spread) =3.80.8% (LIBOR) +3% (Spread) =3.8
- Interest for Year 3: $20,000 x 0.038 = $760
Summary:
- Year 1: $800 interest at 4% rate
- Year 2: $900 interest at 4.5% rate
- Year 3: $760 interest at 3.8% rate
In this example, you can see how a variable interest rate affects the amount of interest you would pay each year. The interest varies from year to year based on changes in the LIBOR rate, which is added to the fixed spread of 3%.
This variability makes budgeting more challenging compared to a fixed-rate loan, where the interest amount remains constant. Also, you bear the risk that your payments could increase significantly if interest rates rise. On the flip side, you also have the opportunity to benefit from lower payments if interest rates fall, as they did in Year 3 in this example.
