As opposed to a fixed interest rate, the variable interest rate is a financing option that can allow a consumer to take advantage of current economic conditions to pay a lower rate of interest on a loan or mortgage. Because the variable interest rate is based on current averages on a national level, the general state of the economy can drive down interest rates for extended periods of time. During these periods, the consumer can save a substantial amount off the original or starting rate of interest associated with the transaction.
Variable interest rates do carry a greater degree of risk than going with a fixed rate. Because the fixed rate of interest will remain constant for the duration of the loan or mortgage, the investor knows how much he or she will pay in interest over the long term. With a variable interest rate, this is not the case. The investor may eventually pay much less interest than indicated at the time the contract went into effect and the completion of the terms. On the other hand, the average rate of interest may climb above the initially quoted rate. When this happens, the investor will pay much more in interest over the life of the mortgage or loan.
Federal treasuries often define the conditions that impact interest rates during a given period of time. The variable interest rate will be determined based on those findings and can impact a number of investments. Variable interest rates may be influenced by money market rates, a lender’s cost of funds, or a current index that is related to the type of loan that is extended to the investor.
One common application of a variable interest rate is to combine it with a fixed rate in what is known as an adjustable rate loan. Generally, this type of loan begins with a specified period of years in which the borrower is guaranteed a specific rate of interest. The rate remains the same regardless of general economic conditions. At the end of that period, the interest rate migrates from a fixed to a variable rate and is applied to any remaining balance due on the loan.