If you’re shopping around for loans, you might notice that some have a “fixed rate” and others have a “variable rate.”
A variable-rate loan may start with a lower rate than a fixed-rate loan, which can make it a more appealing option. When money’s tight, the type of interest rate you choose can have a big impact on your financial stability and monthly budget.
But variable rates can change, which means your monthly payment could also change. It’s possible that over time, your lower rate could soar. While not a deal-breaker, it’s something to keep in mind when weighing whether to sign on to a variable-rate loan.
Let’s learn more about what a variable-rate loan is, its pros and cons, and when it could make sense for you.
What Is a Variable-Rate Loan?
A variable-rate loan is a loan where the interest rate can change over time. That means your monthly payment could go up or down based on the market.
This type of loan starts with a benchmark rate and then adds an additional percentage. That benchmark is called an index, and the lender’s extra amount is called the margin.
Together, these numbers make up your variable interest rate. This percentage determines how much you’ll pay every month.
For example, if the index is 4% and the lender’s margin is 3%, your interest rate would be 7%. If the index later rises to 5%, your new rate could become 8%.
On the other hand, if the index drops, your rate could go down, too. That’s the main idea behind variable-rate lending — it can go either way.
What Makes the Rate Change?
With a variable loan, the rate doesn’t stay locked in forever. After the loan is issued, the lender checks the index at certain times and updates your rate based on that number. This process is called a reset.
The reset schedule depends on your contract. Some variable-rate loans adjust every month, while others change every six months, once a year or more infrequently.
Such timing matters because the more often a rate resets, the more often your payment can change. Changing interest rates are the main trade-off with a variable-rate loan.
The Different Types of Variable Rate Loans
Not all variable-rate loans are the same. Let’s look at the different types of loans you might see with a variable interest rate:
- Mortgages: Have you ever wondered, “How does a variable rate mortgage work?” Here’s the short version: Your interest rate is tied to an index and can adjust over time, which means your monthly payment may change. Variable-rate mortgages usually have lower introductory rates but involve larger loan amounts. That means even a small change in your rate can have a big impact on your monthly payment.
- Personal loans: A variable-rate personal loan works similarly to a mortgage, but on a smaller scale, and usually with shorter repayment terms of around two to seven years.
- Student loans: Federal student loans almost always have fixed interest rates. So, if you see variable rates on a student loan, it’s probably from a private lender. These rates tend to change monthly or quarterly, and your payments could increase over time.
Regardless of which type of loan you need, variable rates can have a big impact on your monthly budget. Even a 1% increase in a $150,000 mortgage can have expensive consequences.
Deciding If a Variable Rate Loan Is for You
A variable-rate loan isn’t necessarily good or bad. It can be helpful in some situations, but it’s not for everyone. Weigh the pros and cons to decide if it’s a fit for your financial goals.
When It Makes Sense
A variable interest rate loan can be a good fit if:
- You plan to pay off the loan quickly: With a shorter timeline, there’s less chance for the variable lending rate to rise significantly before you pay off the loan.
- You can handle some payment changes: If your budget has a little breathing room, you may be able to absorb fluctuations in your variable loan payment.
- You’re comfortable with some financial uncertainty: Variable-rate loans can save money at times, but your interest rate and monthly payment may increase over the life of the loan.
When to Skip Variable Rate Loans
So, what’s the danger of taking a variable-rate loan? There are some risks, including:
- Payment increases: If rates rise, your monthly payment may increase significantly, depending on your loan amount.
- Risk associated with long payment timelines: The longer you carry the loan, the greater the chance that rates will rise. If your budget is already stretched, even a small increase in variable-rate loan payments can be a big deal.
- Budgeting challenges: Variable payments can make it harder to plan your monthly expenses, especially if you rely on consistent payment amounts to manage your budget.
A Lower Rate Today, But What About Tomorrow?
Variable-rate loans work better for some situations than others. If you leave room in your budget for changes, a variable-rate loan may feel manageable. If your finances are already stretched thin, though, a payment that increases at the wrong time can be a real problem.
That’s why it helps to understand the meaning of a variable-rate loan before you sign anything. Do your homework to find a loan that best fits your needs, both today and in the future.
