A variable interest rate, which is also commonly known as a floating or adjustable rate, is used as part of a financing agreement that represents a rate of interest that can change periodically. In contrast with fixed rates that have the same interest rate over a term, variable interest rates can fluctuate based on market trends, index rate changes, and other factors.
This means that instead of having the same principal and interest payment every month, the required repayment amount of a financing agreement may vary depending on the current applicable rate and may increase or decrease accordingly.
Key Takeaways:
- Variable interest rates change throughout the course of the loan and will impact the overall cost of financing.
- Rates may be updated based on the benchmark rate index used to determine the initial interest rate.
- Numerous loan types can have a variable interest rate, including mortgages, lines of credit, and credit cards.
If you’re looking for a loan with a variable interest rate, check out Lendio. As a broker with over 75 lenders in its network, it offers a large variety of lending products, and you can review all of your potential financing options with a single application. Visit its website to learn more.
How Does a Variable Interest Rate Work?
Variable interest rates are tied to a benchmark rate index, along with additional basis point margins designated by a lender. Such rate indexes can include the Secured Overnight Financing Rate (SOFR), the federal funds rate, and the Prime Rate. The rate index used will vary depending on the loan type and lender.
Since it’s variable, the interest rate can fluctuate when the rate index rises or falls, depending on market conditions. The applicable rate will adjust and change periodically and impact the total cost of borrowing based on the varying monthly principal and interest payments required of the outstanding balance. As such, this may increase the level of risk to the borrower, as they may end up paying more over time compared with a fixed-rate loan. In turn, if market conditions remain favorable, the borrower may also pay less if rates stay low throughout the financing term.
When determining a variable rate, lenders will use the applicable rate index and apply a basis point margin that will be determined by your qualifications, along with other small business loan requirements. Notably, financing agreements typically have a maximum interest rate limit, in which during the course of the loan, the rate cannot exceed a specified percentage, no matter the index rate. So while rates may increase, borrowers aren’t subjected to drastic interest rate changes.
Example of a Variable Interest Rate
To demonstrate how rates may fluctuate, the simplified example below represents a loan with a variable rate that’s based on a benchmark index rate plus a lender’s basis point margin. Throughout the course of the loan, the variable interest rate adjusts as the index rate changes.
Ex. 7.5% + 2% = 9.5% (starting variable rate)
This represents the initial variable rate when the loan agreement was signed and what the borrower is currently expected to pay in interest on the outstanding balance of the loan per month.
Ex. 7% + 2% = 9% (rate change per index rate decrease)
This represents an index rate decrease of 0.5%. As such, the monthly interest rate on the loan will be lower and reflect favorable market conditions.
Ex. 8% + 2% = 10% (rate change per index rate increase)
This represents a rate index increase of 1% from the prior example. Economic downturn may be a factor in rate increases and inevitably make the monthly loan repayment amount more expensive.
Variable Interest Rate Loans and Mortgages
Numerous loan types can have a variable interest rate. It depends on the financing needs and preferences of the borrower, but most lenders can issue a variable rate for most business loans. The impact of a variable rate can vary depending on the type of financing you need and which index rate is used. Common financing types include:
- Lines of credit: Both secured and unsecured lines of credit can have a variable interest rate. In fact, most lines of credit have a variable interest rate due to the fact that they are a revolving credit facility that can be utilized for short-term financing needs.
- Mortgages: Mortgages can also have a variable rate, although they are more commonly referred to as adjustable rate mortgages (ARMs). These often offer low initial interest rates, in which the borrower can later convert into a fixed-rate mortgage.
- Working capital loans: If it’s the preference of the borrower, most lenders can accommodate variable interest rates for a wide variety of businesses depending on your qualifications and financing needs.
Read our guide on how to get a small business loan to help you with the application process and to learn how to increase your odds of approval.
Variable Interest Rate Credit Cards
Credit cards are also one of the most common types of financing with a variable rate. They commonly have what’s known as an Annual Percentage Rate (APR) that is associated with an index rate that impacts the total repayment owed.
Since credit cards act as a revolving credit facility that can be repaid and reused on an as-needed basis, a variable rate is suitable for this form of short-term financing. This allows the cardholder to not be locked into a high fixed rate or a fixed monthly payment.
If you’re in need of a business credit card, we recommend reading our article on the best small business credit cards to find one that works for you.
Pros & Cons of Variable Interest Rates
| PROS | CONS |
|---|---|
| Variable rates can often be lower than fixed interest rates, depending on the market. | Rate fluctuation can impact the borrower’s monthly payment schedule. |
| When rates are low, the borrower may save on overall financing costs when compared to a fixed rate. | Rates can change at any given time. |
| Variable rates can provide flexibility for borrowers looking for favorable loan terms. | Financing can be more expensive overall if high rates are implemented throughout the loan. |
When to Choose a Variable Interest Rate
Generally, borrowers can benefit from financing with a variable interest rate in a market where current rates are low or expected to drop in the future. For borrowers looking to utilize a variable interest rate, there are a few instances where it may be best applicable. This might include borrowers:
- Looking to take advantage of favorable market conditions: If current market rates are low, some borrowers may be able to save money overall by taking advantage of the initial low rates.
- Needing short-term financing options: For borrowers requiring funds for a short-term financing opportunity, a variable rate may be cheaper at that point in time.
- Wanting flexibility to make additional payments or increase loan amounts: Increased flexibility in loan terms can be a great advantage for borrowers who don’t want or need to be locked into a set monthly repayment amount.
Variable vs Fixed Interest Rates
Essentially, the differences between variable and fixed interest rates are whether or not the interest rate remains the same throughout the financing term.
Fixed rates will be assigned at the beginning of the term and agreed upon beforehand. The rate won’t change and will have the same principal and interest payment amount due each month. This pays down the debt in equal installments until maturity.
This differs from variable interest rates, where the interest rate can fluctuate higher or lower over the course of the financing term, and payments can vary from month to month depending on the current assigned rate. This can mean that the borrower may pay more or less in installments until maturity.
Frequently Asked Questions (FAQs)
The risk involved with variable rates lies within the market. Rates can fluctuate based on a variety of market factors, and lenders can adjust rates accordingly. Most of the risk is posed to the borrower since it may disrupt their monthly payments in terms of what they can expect to pay. Also, in the event rates increase, they may pay more overall when compared to financing with a fixed interest rate.
There are a wide variety of loan types that can have a variable interest rate associated with them. Whether it be a mortgage, a line of credit, a credit card, or even a personal loan, most loans can have a variable rate if the lender allows and it’s the borrower’s preference.
Credit cards and lines of credit are typically the most common financing options to have a variable interest rate. This is mainly because they are considered to be a revolving credit facility, which allows them to be repaid and reused over time.
Bottom Line
Variable interest rates can be associated with many types of financing and are commonly used by borrowers looking to take advantage of current market conditions to obtain favorable rates and terms. However, a variable rate may carry more risk compared with a fixed rate loan in the event rates increase and the borrower ends up paying more overall. That said, it’s still a favorable option if it fits your business needs and budget.
