Variable Interest: Definition, Formula, and Loan Types Using Variable Interest

Understanding the Concept of Variable Interest

A variable interest rate is where people obtain a loan with a fluctuating interest rate. The rates keep changing over the loan period. It differs from a fixed interest rate that remains constant throughout the loan term. A variable interest rate comes with various features. First, it has a fluctuating interest rate. The borrower’s monthly payments go up or down depending on the initial interest rate. Another feature is that a variable interest rate is tied to a financial index. An example is a LIBOR ( London Interbank Offered Rate) or the prime interest. It means that the loan’s interest rate fluctuates depending on the index. A variable interest rate is important to borrowers in various ways. Borrowers have the potential to save by using a variable interest rate.

It is because the rates sometimes fluctuate and lower the interest rates. Variable interests help in reflecting changes in market conditions. Another benefit of variable interest rate is that it offers risk management. It allows lenders to adjust the rates to ensure that they don’t lose money due to market fluctuations. Likewise, borrowers are protected. Their rates have the potential of getting lower due to market changes, which helps to save money. Most people find the variable interest rate formula confusing. It’s because it combines the loan term, interest rates, and other fees or charges. Below is a typical formula for calculating the variable interest rate:

Total cost = (Loan principal + interest) x (1 + (interest rate / 12))^(number of monthly payments)

Various loans use variable interest. The loan types using variable interest include mortgages, student loans, and business loans. Borrowers of these loans agree to repay the principal with a variable interest rate. These loans’ interest rates are tied to an index, like a prime rate. The index fluctuates based on economic conditions. 

What is a Variable Interest Rate?

A variable interest rate is a financial product with fluctuating interest rates. These rate keeps on changing based on specific triggers or conditions. Borrowers looking to save money on interest rates find these loans helpful. The history of variable interest rates dates back to the 1970s. The idea originated in Europe and was first used in the USA in 1974. It was a period of high inflation and unstable interest rates. The idea of variable interest was born to cushion borrowers and lenders from unpredictable rates. It ensured that both lenders and borrowers benefited from the fluctuating rates. Today, variable interest is used in many financial instruments. These include mortgages, bonds, and loans.  Today they are one of the most successful ways of borrowing. They have lower introductory rates compared to fixed interest rates.

How Variable Interest Rate Work?

A variable interest rate is where customers repay their loans with fluctuating rates. The rates rely on a set index plus a margin. Suppose a lender provides an interest rate per the prime rate plus 2%, and the current prime rate is 3%. The loan’s interest rate becomes 5%. Suppose the prime changes to 4% and the loan’s interest rate increases to 6%. Most borrowers tend to benefit from variable interest rates. It is because these rates start lower than fixed interest rates. They, in turn, make lower monthly payments. Sometimes, variable interest rates are riskier. Suppose the underlying index increases. The loan’s interest rate goes up, resulting in costlier monthly payments.

What are the other terms for Variable Interest?

The other terms used to describe variable interest rates are as follows:

  • Floating rate. Most people use the floating rate term to describe a variable interest rate based on an underlying index that fluctuates over time. 
  • Adjustable rate. It is a term people use to describe an adjustable variable interest rate based on a predetermined schedule. 
  • Hybrid rate. The term describes a variable rate that has features of both variable and fixed rates. Sometimes it is fixed for a set period and then becomes variable for the remaining term.

What is an Example of Variable Interest Rate?

An example of a variable interest rate is a mortgage loan. The loan has an interest rate based on the prime rate plus a margin. The prime rate is a benchmark interest rate used as a reference for lending decisions. It relies on the rates banks lend to their most creditworthy borrowers. Borrowers must understand the terms of a variable interest rate loan. They must manage the risk of fluctuating payments before agreeing to one. They must consider income stability, budget, and overall financial goals.

What Types of Loans Use Variable Interest Rates?

1. Personal loans

Personal loans are unsecured loans typically used for various purposes. Borrowers use them for debt consolidation, home improvement, or financing a large purchase. Banks, credit unions, online lenders, or other financial institutions offer personal loans. Some of them use variable interest rates. It is because they have lower initial borrowing costs to borrowers. However, they come with the risk of fluctuating payments over time. Borrowers must consider the loan terms and their ability to manage the risk of fluctuating payments before agreeing to one. They must understand the overall cost of borrowing, including any fees or charges associated with the loan.

2. Derivatives

A derivative is a financial instrument that derives value from an underlying asset. These assets include a commodity, currency, or bond. They often transfer risk or speculate on the future movement of the underlying asset. Derivatives use variable interest rates in several ways. For example, a variable rate swap. It is a derivative in which two parties agree to exchange a series of payments based on a floating interest rate. One party pays a fixed interest rate, while the other a variable interest rate based on an underlying index. Variable interest rates offer the potential for higher returns or allow for risk transfer between parties. Other variable interest rate derivatives include interest rate caps, floors, and collars. They allow parties to hedge against the risk of interest rate movements or speculate on future interest rate movements.

3. Credit Cards Loans

A credit card loan is a type of loan that lets people obtain money against their credit card limit. Borrowers use these loans for a variety of purposes. The most common uses are consolidating debts, paying for unexpected expenses, or a large purchase. Several reasons a credit card company offers a loan with a variable interest rate. The main reason is to entice borrowers to continue using credit cards. It is because they get a lower initial interest rate. 

4. Corporate Bonds

A corporate bond is a debt security issued by a corporation and sold to investors. The corporation’s assets secure the bonds and typically have more than one year term. Corporate bonds usually have a variable interest rate. It means the interest payments on the bonds changes over time. Using a variable interest rate on a corporate bond allows the issuer to take advantage of falling interest rates. Suppose rates fall. The issuer saves money by refinancing the bond at a lower rate.

5. Mortgages

A mortgage is a loan used to purchase a property. A variable interest rate on mortgage changes periodically per the changes in a designated index. The borrower’s interest rate is directly tied to the index’s movements.  The main reason why lenders like to use variable interest rates is that it protects them from fluctuations in the market. Suppose the interest rates are high. More people are likely to default on their loans. With a variable interest rate, lenders increase the interest rate on a mortgage when rates are high. They decrease the interest rate when rates are low. 

What is the Formula for Variable Interest Rate?

The formula for calculating the variable interest on a loan is based on the following elements.

  • Principal amount.
  • Interest rate.
  • Interest period.

Here is an example of a table showing the calculation of the variable interest. It is based on a loan with a principal amount of $10,000, a variable interest rate of 5%, and an interest period of one year:

Year Variable interest Amount
1 $500 $10,500
2 $525 $11,025
3 $551.25 $11,576.25

In this example, the variable interest rate is based on the prime rate plus a margin. The interest rate increases by 0.25% each year. It increases the variable interest and the overall amount owed.

How to Calculate Variable Interest?

To calculate the variable interest on a loan, borrowers must follow these steps. 

  • Determine the principal amount. The principal amount is the initial amount of money borrowed. It is the starting point for the calculation.
  • Determine the interest rate. The interest rate is the percentage of the principal amount charged for borrowing money. It is a key factor in determining the interest owed or earned.
  • Determine the interest period. The interest period is the time the interest is calculated. It is typically a year, but it is a shorter or longer period depending on the terms of the loan or investment.
  • Calculate the interest. To calculate the interest, multiply the principal amount by the interest rate. Divide the result by the number of periods in the interest period. For example, for a principal amount of $10,000, an interest rate of 5%, and an interest period of one year, the calculation is ($10,000 * 5%) / 1 = $500.
  • Add the interest to the principal. Add the interest to the principal amount to determine the total amount owed or invested. Continuing with the example above, the total amount owed is $10,000 + $500 = $10,500.

How much can a Variable Interest Rate vary?

The amount that a variable interest rate varies depends on several factors. These include the loan terms and the underlying index on which the interest rate is based. A variable interest rate on loan is used on an index, such as the prime rate. It is a benchmark interest rate that financial institutions set. The prime rate varies over time based on market conditions and the central bank’s policies. Some are based on other indices, such as the LIBOR (London Interbank Offered Rate) or the federal funds rate. These indices fluctuate over time based on market conditions and the central bank’s policies.

How often do Variable Interest Rates change?

The frequency at which variable interest rates change varies depending on two factors. They are the terms of the loan and the underlying index on which the interest rate is based. Some variable interest rates on loans are based on the prime rate. It means they change whenever the prime rate changes. Others are based on indices, such as the LIBOR (London Interbank Offered Rate) or the federal funds rate. They change based on the movements of the underlying index. These indices fluctuate based on market conditions and the central bank’s policies. The frequency at which they change varies over time.

Who benefits from a Variable Interest Loan?

Variable-interest loans benefit both borrowers and lenders. It depends on the terms of the loan and the movements of the underlying index. Borrowers benefit from a variable interest rate loan if the interest rate is lower than a fixed-rate loan. The underlying index must remain stable or decrease over time. In this case, the borrower’s monthly payments are lower than a fixed-rate loan. Lenders benefit from a variable interest rate loan if the underlying index increases over time. In this case, the lender earns a higher loan return as the interest rate increases.

What are the Limitations of Variable Interest?

  • Fluctuating payments. The interest rate on a variable interest rate loan changes over time per an underlying index. Likewise, the amount of the monthly payments changes. It makes it difficult for borrowers to budget for their monthly payments.
  • Higher risk. Variable interest rate loans or investments are riskier than fixed-rate loans. They have the potential for fluctuating payments. Thus they are less attractive to some borrowers or looking for a more predictable financial product.
  • Difficulty comparing rates. It is difficult to compare the rates of variable interest rate loans to fixed-rate loans. It is because the rates fluctuate over time. It makes it challenging for borrowers to determine the most cost-effective option.

Is variable interest better for investing?

Yes, variable interest often offers potential benefits to investors, such as the potential for higher returns if the underlying index increases over time. However, they also come with the risk of fluctuating returns over time. These are less attractive to some investors looking for a more stable and predictable investment.

What types of investments make use of Variable Interest?

Here are some types of investments that make use of variable interest:

  • Variable rate bonds. These bonds pay a variable interest rate based on an underlying index, such as the prime rate or the LIBOR. Their interest rates fluctuate over time, resulting in fluctuating returns for the investor.
  • Variable rate mutual funds. These mutual funds invest in various securities. These include stocks, bonds, and cash. They pay a variable interest rate based on the returns of the underlying securities. The interest rate on these mutual funds fluctuates based on the performance of the underlying securities.
  • Variable rate annuities. These insurance products provide a stream of income to the investor in exchange for an upfront payment. Their interest rates are variable, meaning income payments fluctuate over time. They change based on an underlying index, such as the prime rate.

These investments use variable interest to offer the potential for higher returns. It happens if the underlying index increases over time. However, they come with the risk of fluctuating returns over time. Thus some people find them less attractive if looking for a more stable and predictable investment.

What is the difference between Variable Interest and Fixed Interest?

Variable interest and fixed interest refer to how the interest rate on loan is determined. Here are some key differences between the two:

  • Fluctuating vs. stable. The interest rate on a variable interest loan fluctuates over time based on an underlying index. The interest rate on a fixed-interest loan remains stable throughout the loan term. 
  • Risk profile. Variable interest rate loans are riskier than fixed-rate loans. It is because of the potential for fluctuating payments or returns. It makes them less attractive to some borrowers or investors looking for a more predictable and stable financial product. 
  • Comparison. It is difficult to compare the rates of variable interest rate loans to fixed-rate loans. The rates fluctuate over time. They make it more challenging for borrowers to determine the most cost-effective option.
Personal Finance Writer at Payday Champion

Kathy Jane Buchanan has more than 10 years of experience as an editor and writer. She currently worked as a full-time personal finance writer for PaydayChampion and has contributed work to a range of publications expert on loans. Kathy graduated in 2000 from Iowa State University with degree BSc in Finance.

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