What is a variable interest rate?

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In a Nutshell

A variable interest rate is tied to a benchmark interest rate known as an index. When the index changes, the interest rates you pay for your loans can change, too. Having a variable interest rate can mean spending more to pay off your debt than you expected. Before you take on a new variable rate loan or credit card, make sure you understand the terms.
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When you take on a new loan or credit card, you may take it for granted that the interest rate will always stay the same. But that’s not necessarily true.

Some financial products come with a variable interest rate, meaning the amount of interest you’re charged on the money you’ve borrowed can be subject to periodic changes.

Many financial products can come with variable interest rates, including …

  • Credit cards
  • Adjustable-rate mortgages
  • Private student loans
  • Auto loans

Lenders may change their variable rates in response to changes in important indexes, like the prime rate. When the index that your variable interest rate is linked to changes, your lender may change your interest rate. And when that happens, your monthly payment can go up or down as a result.

But not all loans come with variable rates. If a loan has a fixed interest rate, that means it’s not subject to the same index rate changes.

Taking on a loan with a variable interest rate can be a financial risk, but in a few rare cases it can be a better option than a fixed-rate loan. Keep reading to learn more.

How often does a variable interest rate change?

Interest rate changes can depend on the terms of your financing and which index rate your lender uses as a benchmark. For example, credit cards are most commonly tied to The Wall Street Journal’s U.S. prime rate, which is the base rate on corporate loans posted by at least 70% of the 10 largest U.S. banks.

The number of rate changes you’re subject to can vary greatly. For example:

  • Variable-rate student loans can change periodically.
  • Variable-rate credit cards typically change in tandem with Federal Reserve changes to the federal funds rate, which can happen multiple times a year.
  • Adjustable-rate mortgages generally stay at the same rate for the first three to five years, and then change periodically.

Will I be notified that my rate is changing?

The Truth in Lending Act aims to ensure that you get information about your interest rates before you close on a loan. Because of the Truth in Lending Act, lenders are required to disclose your APR and whether it’s variable or fixed when you apply for a mortgage or auto loan.

For some loans you’ll also receive a notice before each rate change goes into effect. With an adjustable-rate mortgage, for example, your loan servicer is required to give you notice at least seven months before the first increase in your mortgage payment. After that you’ll be notified two to four months in advance of each change if that change impacts your monthly payment.

The Truth in Lending Act requires creditors to provide you with information about your APR and whether it’s variable or fixed before you open a credit card, too.

Credit card issuers aren’t required to notify you when your variable rate is going to change, but some do so voluntarily.

When is a variable rate best?

Variable interest rates can be risky. Having your debt payment go up monthly, quarterly or even annually can make it difficult to stick to a budget. But in some cases, a variable rate might be right for you.

Variable-rate credit cards

Many credit card APRs aren’t fixed, so you may have no other option than to get a variable-rate card. But unlike loans, you can generally avoid paying interest on purchases you make with a credit card by paying off your balance in full by the due date each month, or during a 0% interest introductory period.

If you do carry a balance on a card with a variable rate, you may be charged more in interest than you’d expect.

When the index tied to your rate goes up, your credit card issuer can choose to apply that increase to preexisting balances. Many credit card companies charge the increased interest for an entire billing cycle, even if the index only increased at the very end of the cycle.

Variable-rate loans

The rates on variable-rate loans may decline when indexes go down, but adjustable-rate mortgages don’t always follow suit. Some even limit how much your interest can decrease.

But under the right circumstances, a variable-rate loan can be more cost-effective than a fixed-rate loan.

That’s because the interest rate on variable loans could start out lower than on fixed-rate loans, and then can increase over time. For adjustable-rate mortgages with an initial fixed-rate period, if you know you’ll be flipping the home or selling it before rates increase significantly, a variable rate could be a money saver.

But if you stay in the home past the fixed-rate period, your payments could increase drastically. That could make it hard to pay down your balance and ultimately result in you going upside down on your mortgage.

What does it mean to be “upside down” on a loan?

When you owe more on a secured loan than your property is worth, your loan is considered to be upside down. This is also called negative equity, or being under water.

Bottom line

A variable interest rate can cause your overall debt repayment to cost you more. That’s why it’s important to pay attention to your interest rates and do some rate comparisons before you apply.

Before you take on new variable-rate financing, whether that’s with a credit card or a mortgage, make sure you’re prepared for your interest rate and monthly payments to potentially increase. Being prepared for this can help you determine whether your budget can withstand a worst-case scenario.

About the author: Sarah C. Brady is a San Francisco–based financial consultant, workshop facilitator and writer. In addition to writing for Credit Karma, Sarah writes for Experian, LendingTree, Magnify Money, MSN News and more. In her … Read more.