Variable Rate Loan
A Variable Rate Loan, also known as a Floating Rate Loan or Adjustable Rate Loan, is a loan in which the interest rate charged on the outstanding balance varies as market interest rates change. As a result, your payments will vary as well, either semi-annually, annually, or in some cases, even monthly. These loans are generally tied to an underlying benchmark interest rate or index such as the Prime Rate, LIBOR (London Interbank Offered Rate), or a Treasury Index.
Features of a Variable Rate Loan:
- Initial Rate: The loan often starts with an initial rate that may be lower than the rate offered on a fixed-rate loan.
- Rate Adjustment Period: The interest rate changes at predetermined intervals, such as every month, every six months, or every year.
- Benchmark + Spread: The variable rate is usually determined by adding a fixed “spread” to a variable benchmark rate.
- Rate Caps: Some variable rate loans include caps on how much the interest rate or the payment can increase at each adjustment period or over the life of the loan.
- Risk and Reward: Variable rate loans often offer lower initial rates, but there is the risk that rates (and your payments) will rise in the future.
Example of Variable Rate Loan
Let’s consider an example with a variable rate student loan to illustrate how it would work.
Imagine you take out a $40,000 student loan to pay for graduate school. The loan comes with a variable interest rate, which is determined by adding a fixed spread of 2% to the current 1-Year LIBOR rate. The interest rate is set to adjust annually.
- 1-Year LIBOR Rate: 1.5%
- Your Loan’s Interest Rate: 1.5% (LIBOR) + 2% (Spread) = 3.5%
- Annual Interest: $40,000 * 3.5% = $1,400
- Monthly Interest: $1,400 / 12 = $116.67 (approx.)
For the first year, you would pay approximately $116.67 per month just to cover the interest, assuming you’re not yet repaying the principal.
Now, let’s assume the LIBOR rate goes up to 2%.
- 1-Year LIBOR Rate: 2%
- New Loan Interest Rate: 2% (LIBOR) + 2% (Spread) = 4%
- Annual Interest: $40,000 * 4% = $1,600
- Monthly Interest: $1,600 / 12 = $133.33 (approx.)
In the second year, due to the increase in the LIBOR rate, your new monthly interest payment would be approximately $133.33.
This time, let’s assume the LIBOR rate drops to 1%.
- 1-Year LIBOR Rate: 1%
- New Loan Interest Rate: 1% (LIBOR) + 2% (Spread) = 3%
- Annual Interest: $40,000 * 3% = $1,200
- Monthly Interest: $1,200 / 12 = $100
In the third year, your monthly interest payment would reduce to $100 because of the decrease in the LIBOR rate.
In this example, the monthly interest payment on your student loan changed each year due to fluctuations in the 1-Year LIBOR rate. If the LIBOR increased, your rate and payments went up; if the LIBOR decreased, your rate and payments went down.
This scenario highlights the risk and reward aspect of variable rate loans. They can be beneficial if interest rates go down or remain stable, but they also carry the risk of increased payments if rates go up. Therefore, when considering a variable rate loan, it’s important to assess your ability to absorb higher payments in case interest rates rise.