Variable rate loans can seem tempting at first glance The interest rates are often lower than fixed rate loans, so your monthly payments start out lower. Who wouldn’t want lower monthly bills? But before you sign on that dotted line, it’s important to understand the potential risks of taking out a variable rate loan.
What Exactly is a Variable Rate Loan?
With a fixed rate loan, the interest rate stays the same for the entire term of the loan. Your monthly payment amounts will not change.
A variable rate loan on the other hand has an interest rate that can fluctuate over time. The rate is tied to an underlying benchmark rate, like the prime rate, that changes periodically. As that benchmark rate goes up or down, so does the interest rate on your variable rate loan.
This means your monthly payment amounts will vary over the life of the loan as the interest rate changes.
The Biggest Danger – Payments Can Increase
The most significant risk of a variable rate loan is that your monthly payments can increase, sometimes substantially. If the benchmark rate your loan is tied to goes up, your interest rate will also rise and your monthly payment will become more expensive.
For example, let’s say you take out a $300,000 30-year mortgage with a 5% starting interest rate. Your initial monthly payment would be around $1,610.
But if the rate later increases to 6%, your payment would jump to $1,799 per month. That’s an extra $189 per month or $2,268 more per year that you’d have to come up with.
And if rates really skyrocket, your payments could become unaffordable. During times of high inflation or Fed rate hikes, benchmark rates can rise dramatically.
The Impact of Rising Rates Depends on Your Loan Term
How much your variable rate loan payments can fluctuate depends partly on the length of your loan term. The longer the term, the more your loan is exposed to interest rate changes.
For instance, if you take out a 3-year variable rate loan, there’s only a short window where the rate can change. But with a 30-year mortgage or student loan, your rate could potentially adjust dozens of times over the life of the loan.
Even small rate increases can really add up over decades. It’s important to consider the long-term picture, not just the teaser rate you start out with.
Beware of “Payment Shock” When Rates Reset
Many variable rate mortgages and student loans have fixed periods where the rate stays the same, followed by periodic resets. This structure is appealing because it locks in a low rate upfront.
But you need to be prepared for “payment shock” when the rate eventually adjusts. Your monthly bill can potentially spike by hundreds of dollars when the reset occurs.
Make sure you budget for this possibility. Don’t take out a large variable rate loan counting on low payments indefinitely.
Your Monthly Budget May Get Tricky
Since variable rate loans involve fluctuating monthly payments, they can make budgeting more difficult. You can’t simply set the same fixed mortgage or loan payment amount on autopilot every month.
As rates change, you’ll have to continually adjust your budget and cash flow. This uncertainty can provide financial planning challenges.
Consider a Rate Cap for Protection
One way to limit risk with a variable rate loan is to make sure there is a rate cap. This sets a maximum limit on how high the interest rate can rise over the life of the loan.
For instance, a 5/1 adjustable rate mortgage may cap rate increases at 2 percentage points above the starting rate during the variable period. This provides some protection against runaway rate hikes.
Shop Around for the Best Loan Terms
All lenders structure variable rate loans somewhat differently. Comparison shop to find the best overall deal.
Look for options like lower margins and caps to limit how much your rate can fluctuate. Avoid loans with prepayment penalties in case you need to refinance later.
Think Carefully Before Agreeing to a Variable Rate
Clearly, variable rate loans come with some inherent risks. Your monthly payments are unpredictable and can increase over time. Make sure you fully understand how the loan works before moving forward.
Weigh the pros and cons carefully based on your individual situation. Be realistic about whether you can afford higher payments in the future. And have a backup plan in case the rate rises down the road.
Consider Your Alternatives
You may decide a fixed rate loan is a better fit if you want payment predictability. Or, a shorter term variable loan can limit risk.
Paying down debt aggressively can also allow you to refinance into a fixed rate loan faster. Come up with a strategy that provides the right balance of risk management.
The Takeaway
While variable rate loans boast lower starting interest rates, the trade-off is your monthly payment amounts can fluctuate. And if benchmark rates increase substantially, variable rate loans can become much more expensive over time.
Make sure you assess your budget and risk tolerance. Have a plan to handle higher payments if rates rise. And look closely at alternatives like fixed rate loans. By understanding the dangers ahead of time, you can make the most informed borrowing decision.
What Is a Variable Interest Rate?
A variable interest rate (sometimes called an “adjustable” or a “floating” rate) is an interest rate on a loan or security that fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically.
The obvious advantage of a variable interest rate is that if the underlying interest rate or index declines, the borrower’s interest payments also fall. Conversely, if the underlying index rises, interest payments increase. Unlike variable interest rates, fixed interest rates do not fluctuate.
- A variable interest rate fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically with the market.
- The underlying benchmark interest rate or index for a variable interest rate depends on the type of loan or security, but it is frequently linked to the LIBOR or the federal funds rate.
- Variable interest rates can be found in mortgages, credit cards, corporate bonds, derivatives, and other securities or loans.
Variable-Interest-Rate Loans and Mortgages
Variable-interest-rate loans function similarly to credit cards except for the payment schedule. While a credit card is considered a revolving line of credit, most loans are installment loans, with a specified number of payments leading to the loan being paid off by a particular date. As interest rates vary, the required payment will go up or down according to the change in rate and the number of payments remaining before completion.
When a mortgage has a variable interest rate, it is more commonly referred to as an adjustable-rate mortgage (ARM). Many ARMs start with a low fixed interest rate for the first few years of the loan, only adjusting after that period has expired. Common fixed-interest-rate periods on an ARM are three, five, or seven years, expressed as a 3/1, 5/1, or 7/1 ARM, respectively. There are also usually adjustment “caps” that put a limit on how much the interest rate can go up or down when it adjusts. You can use an online calculator to get an estimate of current interest rates on adjustable-rate mortgages.
In most cases, ARMs have rates that adjust based on a preset margin and a major mortgage index, such as the LIBOR, the 11th District Cost of Funds Index (COFI), or the Monthly Treasury Average Index (MTA Index). If, for example, someone takes out an ARM with a 2% margin based on the LIBOR, and the LIBOR is at 3% when the mortgage’s rate adjusts, the rate resets at 5% (the margin plus the index).
Fixed Or Variable Rate, Which Is Better?
FAQ
What are the disadvantages of a variable interest rate?
What is a danger of taking a variable rate loan Quizlet?
What are the risks of a variable mortgage?
What could go wrong with a variable rate mortgage?
Should I get a variable rate loan if interest rates fall?
Depending on the terms of your agreement, your interest rate on the new loan will stay the same, even if interest rates climb to higher levels. On the other hand, if interest rates are on the decline, then it would be better to have a variable rate loan. As interest rates fall, so will the interest rate on your loan.
What is a variable interest rate loan?
A variable interest rate loan is a loan where the interest charged on the outstanding balance fluctuates based on an underlying benchmark or index that periodically changes. A fixed interest rate loan is a loan where the interest rate on the loan remains the same for the life of the loan.
Why is a variable loan more expensive than a fixed loan?
The interest rate for a variable loan is generally lower than a fixed loan, especially when the loan is incurred. Loan repayments increase when interest rates rise. Loans may become more expensive than fixed rate loans should interest rates rise quickly. Borrowers face greater risk if overcapitalized or already at repayment capacity.
What are the pros and cons of variable vs fixed rate loans?
When weighing up the pros and cons of variable vs. fixed rate loans, it’s important to know what’s going on with interest rates in the wider market. If interest rates have been falling for a while and it’s likely that they’ll increase soon, then choosing a fixed rate loan will mean you pay less over the long term.
What are the risks of variable interest rates?
Uncertainty: With variable interest rates, there is uncertainty regarding future payments, as rates can increase at any time, leading to higher monthly payments. Financial Risk: If interest rates rise significantly, your budget might be negatively impacted, potentially causing financial strain.
What are the pros and cons of variable interest rates?
Variable interest rates fluctuate over time based on changes in the prevailing market conditions. Pros of variable interest rates include the potential for savings during periods of low interest rates. Cons of variable interest rates include the uncertainty and the potential for higher payments when rates increase. What Are Variable Interest Rates?