Key Takeaways
- Unlike fixed interest rates, variable interest rates can change over the loan term.
- As the interest rate changes, your monthly loan payment can rise and fall over time.
- Generally, a mortgage with a variable interest rate is called an adjustable-rate mortgage (ARM).
- Variable interest rates change over time based on the changes of an underlying index rate.
When considering your loan options, you'll often find both fixed-rate and variable-rate loans. Neither interest rate type is better than the other. Instead, the right choice between these types of loans depends on your unique situation.
This guide to variable interest rates outlines how these loans work, the pros and cons of variable interest rates, and when they might work best for your situation.
What Is a Variable Interest Rate?
A variable interest rate, sometimes called an ‘adjustable interest rate' or ‘floating interest rate,' is an interest rate that can change over the life of the loan. Typically, a variable interest rate is tied to an underlying financial index, and as market conditions change, it can rise and fall.
In contrast, a fixed-rate loan won't have any interest rate changes over the loan term. The table below clarifies the differences between variable-rate loans and fixed-rate loans.
| Variable Interest Rates | Fixed Interest Rates |
|---|---|
|
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Is an adjustable-rate mortgage right for you? Find out with Freedom Mortgage today.
How Does a Variable Interest Rate Work?
A variable-interest rate rises and falls based on changing market conditions. Specifically, a variable interest rate is tied to a benchmark rate index, like the prime rate or the secured overnight financing rate (SOFR). As the index rises and falls over time, the variable interest rate attached to your loan follows suit. But, in many cases, adjustable-rate loans have interest rate caps and floors built in to limit how far the interest rate can rise and fall.
Common Variable-Rate Loan Products
Some loan products commonly offer variable-rate loan options. Explore a few below:
- Adjustable-rate mortgage (ARM): An ARM is a type of mortgage with a variable interest rate. Most ARMs have an initial lower fixed-rate period (commonly 5 years), after which the interest rate can change based on a financial market index.
- Home equity line of credit (HELOC): A HELOC allows you to borrow against the equity in your home. Typically, HELOCs have variable interest rates.
- Personal loans: Many personal loans offer an unsecured borrowing option, meaning you won't have to provide collateral for the loan. You can often use this borrowed money for almost any purpose. In some cases, personal loans have a variable interest rate.
- Credit cards: Most credit cards have a variable interest rate, often relatively higher compared to other loan options.
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Example of a Variable Interest Rate
When choosing an adjustable-rate mortgage (ARM), your interest rate will stay steady for a predetermined initial period. After the initial interest rate period expires, the mortgage rate can adjust to match current market conditions.
For example, let's say you have a 5/1 ARM. Your interest rate will stay the same for the first five years of the loan (the 5 in 5/1 ARM). After which, the mortgage rate may adjust to match current market conditions, within the loan's parameters, once annually (the 1 in 5/1 ARM).
Let's say that market conditions have led to dropping interest rates. It's likely that your mortgage interest rate will fall to match those conditions, leading to a lower monthly mortgage payment. Alternatively, if interest rates rose over the last five years, you might see your interest rate and mortgage payment increase.
If an adjustable-rate mortgage makes sense for your situation, reach out to Freedom Mortgage today.
When Is a Variable Interest Rate a Good Idea?
A variable interest rate loan makes the most financial sense for shorter-term borrowing (if you know you will move or refinance in the next 10 years or less) or for larger home loans. That's because variable-rate loans tend to come with lower initial rates than fixed-rate loans. But since variable interest rates carry the risk of higher payments down the line, make sure to fully understand your benefit from the lower rate compared to your risk, before closing. If you're working with a tight budget that couldn't comfortably absorb a higher monthly payment, sticking to fixed-rate loans might be best.
Pros and Cons of Variable Interest Rates
Every financial product has some risks and benefits to consider, and variable-rate loans aren't any different. Explore the advantages and disadvantages below.
| Variable Rate Pros | Variable Rate Cons |
|---|---|
| Generally, lower interest rates for the first several years. | Difficult to budget for because monthly payments can change after the initial period. |
| Potential for interest rates and the monthly payments to fall over time. | Potential for interest rates and monthly payments to rise over time. |
| Many variable-rate loans come with mortgage rate caps and floors, which limit risk. | Rising interest rates could cramp your cash flow. |
Final Thoughts: Is a Variable-Rate Loan Right For You?
If you are comfortable with taking on the risk of higher payments in exchange for saving money with a lower initial interest rate, a variable-rate loan might make sense for you. When you have a variable-rate loan, such as an ARM, it's important to keep the possibility of rising rates in mind and prepare your finances accordingly.
Want to learn more about your mortgage options? Find out more about or apply for an ARM with Freedom Mortgage today.
Sarah Sharkey is a personal finance writer with a master’s degree in Management from the Hough School of Business at the University of Florida. She enjoys helping people make informed financial decisions and has written for numerous personal finance publications over the last eight years, including Credible, Business Insider, and The College Investor.
With a focus on helping homeowners and homebuyers navigate the home purchasing process, Sarah brings years of experience in sorting through the details of various mortgage types to help readers land on the best course of action for their unique situation.
When not writing about money, Sarah can be found exploring the waters near her coastal home with her husband and dogs. Boating with a book is her favorite combination! You can connect with her on her current blog, The Wildlife Quest.
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