What is a Variable Interest Rate? How Adjustable Rates Work for Loans and Credit Cards

I’ve heard people say that change is one thing you can count on. Anyone who’s taken more than a few trips around the sun can attest to the ever-changing nature of life on planet Earth. That can also be true when it comes to certain lending products.

Consumers pay interest charges when they borrow money from creditors. The amount of interest lenders charge you hinges on a product’s interest rate. When a lending product comes with a fixed interest rate, that means the rate won’t change over the life of the product, but some carry a variable interest rate.

A variable interest rate is one that can fluctuate over time. Variable interest rates are tied to certain benchmarks, like the prime rate, and as a benchmark rate changes over time, so can your interest rate.

Your financial circumstances and appetite for risk will determine whether a product with a variable interest rate is right for you. But let’s not get ahead of ourselves. To make an informed decision about which type of rate — fixed or variable — you want in your next loan or credit card, you’ll need more information.

Although life’s full of changes, you can always count on the power of learning more financial management skills. That’s why I’m here to educate you on variable interest rates

I’ll never forget the sense of panic I felt when I walked into the first day of algebra class and saw equations on the board that mixed letters alongside numbers like it was a normal thing. My young mind raced in search of an explanation for this madness. 

Was the teacher insane? Was this only the first surprise in what would turn out to be a day full of revelations that shattered my perception of reality?  

I can’t answer all those questions, but I do remember that some numbers in algebra are called variables. We’re not going to review algebraic formulas in this article, but we are going to get into some simple math to examine how variable interest rates are calculated and how they can change over time.

Tied to a Financial Benchmark

Variable interest rates are typically tied to prominent financial benchmark rates. The prime rate, which is the interest rate commercial banks charge when they lend to their most creditworthy borrowers, is a common benchmark credit card issuers and other lenders use to calculate a product’s variable interest rate.

A lender may disclose the variable interest rate on a product as a certain rate plus the prime rate. For example, a product with a disclosed rate of prime plus 10% will have an interest rate of 18% when prime is at 8%. See, I told you the math in this article would be straightforward.

Here’s a look at how (and when) the prime rate changed over a five-year period starting in August 2019:

The prime rate isn’t the only benchmark rate a lender can tie a variable interest rate to. Other benchmark rates you may see on loan products include the Federal Funds rate and the Secured Overnight Financing Rate. 

You can try to predict which direction benchmark rates will go in the future, but even financial experts can’t always tell which way economic headwinds will blow in the coming months and years. 

Periodic Adjustments

Creating a budget can help you manage your money and stay on track to reach your financial goals. Forecasting your future expenses is a vital part of forming a budget that’s accurate and actionable. 

Borrowers who own credit products or loans with fixed rates may have an easier time predicting future expenses than those who own products with variable rates.

Lenders must follow certain rules regarding communicating rate changes to their customers. According to the Truth in Lending Act, lenders must inform borrowers how they calculate a variable interest rate and the circumstances that cause them to adjust a rate.

When the benchmark rate for your loan product with a variable interest rate changes, you can expect the interest rate on your product to change. But when the rate will change depends on the practices of your creditor. 

Many lenders review the variable rates for their products at specific times, such as every month, quarter, or year. If a product’s benchmark rate changes during that time, the interest rate will adjust accordingly. 

Other events, including economic factors such as inflation rates, may cause your lender to adjust a variable interest rate. Review your credit card terms and conditions or your loan agreement to learn more about the timing of potential changes to your lending product’s variable interest rate. 

Remember to be mindful of how rate changes may impact upcoming interest charges, monthly payments, and your overall budget.

Variable Rates vs. Fixed Rates

I once had a colleague who wore the same outfit to work every day. He didn’t wear the same articles of clothing on Tuesday that he just wore on Monday, but he put on navy slacks and a white shirt each morning before work. 

The company we worked for didn’t require us to wear a uniform, but he created one for himself because he liked the consistency of presenting the same appearance each day.

Some people like minimizing change. If that sounds like you, then you’ll probably enjoy having a fixed interest rate on your loans and credit cards. 

Despite changes to benchmark rates and fluctuations in key economic indicators, fixed interest rates don’t change. This allows borrowers to plan for future expenses without having to resort to estimations about what their product’s interest rate will be down the road.

Here is a look at how fixed and variable interest rates — or annual percentage rates (APR) — differ for credit cards:

Variable interest rates require more work for borrowers who are trying to anticipate future interest charges, but they also can allow borrowers to save money. 

If the prime rate, or another key benchmark rate, drops, borrowers with fixed interest rates on their lending products won’t benefit from better rates. But borrowers with variable interest rates on their lending products may save money if their rates are adjusted to align with a lower benchmark rate.

Of course, the inverse is also true. But variable rates at least allow borrowers the possibility of saving money on interest in the future.

Lending products aren’t one-size-fits-all. A credit card is a flexible financial tool, but you aren’t going to buy a house on your card. Similarly, I wouldn’t advise applying for a loan to buy a pack of gum.

However, loans and credit cards can both have variable interest rates. Let’s explore how variable interest rates work with different financial products.

Credit Cards

Credit cards are one of the most common forms of financing that can come with a variable interest rate. Interest rates on cards are often tied to the prime rate.

So, when you hear that a change to the prime rate is on the horizon, there’s a good chance that’ll affect your card’s interest rate.

Your monthly credit card statement contains more than just a list of your recent transactions. Changes to your card’s interest rate will also be reflected in your monthly statement. 

Your card issuer may even charge a different variable rate for certain transactions. For example, cash advances often come with a higher interest rate than purchases.

Note that variable interest rates can be capped to prevent your card’s rate from exceeding a certain threshold. Check your card’s disclosures for information regarding variable rate caps so you can understand the maximum interest rate your issuer can charge.

Variable Rate Mortgages

For a lot of people, owning a home is a big part of realizing the American dream. However, buying a house is one of the most expensive purchases many people ever make. 

We all want the chance to make our dreams come true, and lending products can help us reach our goals when we need an infusion of outside funds.

Many prospective homeowners apply for a mortgage when they’re in the market to buy a house. Though many mortgages have fixed rates over the life of a loan, variable-rate mortgages don’t. Adjustable-rate mortgages (ARMs) are a specific form of mortgage in which the loan’s rate is tied to a benchmark rate. 

Adjustable-rate mortgages typically carry fixed rates for initial periods of 3, 5, or 7 years. You’ll see these products referred to as a 3/1 ARM, a 5/1 ARM, or a 7/1 ARM. 

The first number in that description refers to how long, in years, the fixed rate component of a loan will last. The second number is how often the rate can adjust per year once the fixed rate period ends. For example, a 5/1 ARM will have a fixed rate for five years, after which its rate can be adjusted once per year. 

Consumers looking to save money on their mortgage may choose ARMs because they usually begin with a low introductory rate before moving to the variable rate portion of the loan.

There is some unpredictability regarding the future payments you’ll make with an ARM. But most lenders set a cap on the amount an ARM’s rate will increase or decrease, both within a certain period of time and over the life of the loan.

The fixed-rate ARMs charge in the initial period can be lower than the fixed rates lenders offer on traditional mortgages. That means an ARM may be of interest to homeowners who are planning to move or refinance their mortgage before the fixed rate period of their product ends.

Borrowers who expect benchmark rates to go down in the future can also benefit if their mortgage rate adjusts to a favorable rate once the fixed period ends. 

But, no matter how many times you’ve cleaned that little window on your magic 8-ball, the future is still unclear. People who elect to go the ARM route for home financing must prepare for the possibility of their ARM’s rate increasing over time.

Personal Loans with Variable Rates

Other types of loans, especially unsecured personal loans, can have variable rates. Unsecured loans are lending vehicles that aren’t secured by collateral, such as a home or car. 

Much like credit cards and ARMs, personal loans with variable rates are usually tied to a benchmark rate. Traditional banks and private lenders may offer personal loans with variable rates. 

Review the terms of any loan you’re considering applying for to understand how and when a lender calculates variable rates — which can significantly affect your future repayments.

Those seeking flexibility in a personal loan may opt for one with variable rates. Based on your circumstances, you may be able to adjust your repayment plan to take advantage of times when rates are lower and make bigger repayments, reducing your principal balance, when the rate rises.

Variable-rate loans may have better rates at the outset than their fixed-rate counterparts, making them especially attractive to borrowers with short-term financing needs. Variable rates can lead to higher interest charges over time, so do your homework to determine if a personal loan with a variable rate suits your needs.

Our tastes and sense of risk may determine if we’ll enjoy a product we’ve never used before. Whether a lending solution with a variable interest rate is right for you depends on your financial situation and if you can afford big changes. 

• Potential for Lower Initial Rates: If saving money is a chief concern for you in choosing a loan or credit card, then you may seek a product with a variable interest rate. Not only can solutions with variable rates offer lower initial rates than fixed-rate products, but they also allow the borrower to access more favorable rates if a product’s benchmark rate falls in the future.
• Risk of Rate Increases Over Time: Things don’t always go as we expect, and products with variable rates can be more expensive to borrowers if benchmark rates rise. Borrowers may also struggle to forecast future payments and save enough to cover times when variable rates increase, making budgeting less impactful.
• Limited Control for Borrowers: You can choose a product with a fixed or variable interest rate, but if you choose a variable rate solution, you can’t influence the rate. Variable rates move with the market, not a borrower’s preferences. Borrowers must accept rate adjustments in stride and keep up with interest expenses.

Determine how each of these potential benefits or risks will impact your financial situation. You may be in a perfect position to take advantage of a variable interest rate product — or one could sink you financially.

Variable interest rates aren’t for everybody, but they have advantages, including the potential to cut costs. Borrowers should carefully weigh the risks and rewards of choosing a lending product with a variable interest rate to ensure it aligns with their financial strategy.

Choosing a lending solution with a variable rate may sound wise, but be prepared for how you’ll pay when the rates inevitably rise.