Politics & Society

Learn About Variable Interest: Definition of Variable Interest in Economics

Written by MasterClass

Apr 30, 2019 • 5 min read

When you borrow money from a bank, a credit card company, or another type of lender, you are charged interest—money you must pay to your lender for the service of advancing you money. Many of these interest rates are fixed; they will not change. But some interest rates do change over time, and these are called variable interest rates.

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What Is Variable Interest Rate?

A variable interest rate changes over time, in accordance with market conditions or a lender’s policies. Typically a variable-rate loan will start relatively low: this entices borrowers to choose that particular lender over others who might initially charge more interest. But variable rate loans can be risky over time because they are liable to increase with inflation, or when the lender institutes its own internal rate changes.

What Is the Difference Between Variable Interest and Fixed Interest?

Fixed rate interest does not change over the life of the loan. This means that if you borrow money at a fixed interest rate, you will always owe the same interest percentage on your unpaid balance. Variable interest rates, on the other hand, can rise over time, making them a risky proposition for many borrowers. But variable interest rates can also decrease over time, particularly in a contracting economy.

Borrowers who prefer fixed interest rates often include:

  • Those who prefer predictability and limited exposure to risk. They’re specifically looking to avoid the uncertainty of future interest rate changes and want an interest rate that will stay the same throughout the entire loan term.
  • Those who want a standard monthly payment to their lender. These monthly loan payments are divided between paying down the principal (the amount they originally borrowed) and interest on the amount still owed
  • Borrowers with a limited credit history or even a bad credit score. In the U.S., these borrowers may specifically seek a loan based on the federal fixed rate, which is set by the federal government and applies to all borrowers regardless of their credit status. Student loans often fit into this category, since they’re typically issued to young people without much of a credit history.
  • Those who take out a new loan during a period of low-interest rates. Low rates typically occur when the economy is thought to be underperforming. As such, when the economy rebounds, rates rise. But even if rates do rise, borrowers locked into a fixed rate loan will never face increased interest percentages.

Borrowers who prefer variable interest rate loans often include:

  • Those who plan to pay off their loan quickly. This lets them take advantage of a low initial interest rate, with the goal of having paid off the full loan amount before loan rates increase.
  • Those who have good credit scores that qualify them for a variable rate loan that may be more favorable in the short term. Young people wishing to borrow for their education may take out a private student loan with a variable interest rate—provided that they have a credit score that their lender considers adequate. By contrast, federal loans from the government always are set to a fixed rate and are preferred by those who can’t afford the risks associated with variable-rate student loans.
  • Credit card borrowers. Nearly all credit cards operate on variable rate interest, which is only charged on balances that aren’t paid off at the end of a billing statement.

What Is the Significance of Variable Interest in Economics?

Variable rate consumer loans aren’t simply set by the whims of a lender. Rather, they are based off one of two benchmark index rates:

  • The Prime Rate. The prime rate is derived from the federal funds rate, which is the interest rate that banks charge each other for overnight loans made to fulfill reserve funding requirements. The United States Federal Reserve enacts policies to manage the federal funds rate, which effectively means that the prime rate is directly linked to a government’s monetary policy.
  • The London Interbank Offered Rate, often abbreviated to LIBOR. This is quite similar to the prime rate, but it is less reflective of U.S. Treasury securities than the prime rate is. The LIBOR is largely derived by surveying banks and asking them to estimate the rate at which they think they could borrow from peer institutions.

The prime rate and the LIBOR, which are listed in financial publications like the Wall Street Journal, are the starting points for commercial lenders. Those lenders then add their own margin of interest to generate their own profit. The benchmark rate plus the lender’s additional margin adds up to produce the actual rate charged to a consumer.

Examples of Variable Rate Interest

Variable rate interest exists in multiple segments of the market. Here are a few ways variable rates show up in real life.

  • Credit card companies typically set their rates using the prime rate as their benchmark. They then add additional percentage points to pad their own internal profits. Because both the prime rate and the credit card company’s internal profit margin may change over time, borrowers effectively pay a variable annual percentage rate (or APR). In fact, many credit cards initially offer a zero percent APR, but it can quickly rise by dozens of percentage points.
  • The vast majority of auto loans involve a fixed rate, although some lenders will offer a loan that combines fixed and variable rates. For instance, a 5/1 adjustable-rate mortgage starts with a fixed rate for five years and then adjusts every year thereafter.
  • Adjustable-rate mortgages offer home buyers extremely low rates to begin with. Typically they’re accompanied by minimal down payments so that buyers can get “a lot of house” without paying much up front. When buyers compare these to a more traditional financing, like a 30-year fixed mortgage, the adjustable rate options look enticing. But these rates can quickly increase, which can make it difficult for borrowers to cover a mortgage payment down the road. Many homebuyers defaulted on their adjustable rate mortgages in the mid-2000s. This led to a mortgage crisis that resulted in the worst economic recession since the Great Depression of the 1930s. Most adjustable rate mortgages come with a cap. These caps cover the maximum amount the rate can change the first time it’s adjusted, the amount a rate can change during each subsequent adjustment period, and the highest amount a rate can be raised over the life of the loan.

While most commercial variable-interest loans include a cap, personal loans rarely do. As a result, some unscrupulous individuals will extend variable-rate personal loans to others and then exorbitantly raise interest rates. Fortunately, this is rare: most personal loans are offered at a fixed rate.

Learn more about economics and society with Paul Krugman here.