Variable Interest Rate – Definition

Cite this article as:"Variable Interest Rate – Definition," in The Business Professor, updated May 30, 2019, last accessed October 27, 2020, https://thebusinessprofessor.com/lesson/variable-interest-rate-definition/.

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Variable Interest Rate Definition

Variable interest rate is an amount on top of a given loan or security. It changes over time because it is based on a standard interest rate that changes from time to time. For example, if you borrow a loan from a bank, and the standard rate decrease, the interest at which you borrowed loan at also decrease. But, if the benchmark interest rate increases, the rate at which you borrowed a loan also increases.

Generally, the variable interest rate works best for banks. For instance, if you borrow money from a bank at a variable interest rate of seven percent with an additional index rate which might be five percent. Therefore, one will pay the loan with an interest rate of 12%. However, if the index rate appreciates from five percent to let’s say seven percent, then the interest on the loaned amount becomes fourteen percent as a result.

A Little More on Variable Interest Rate Loans

The variable interest rate index charged by financial institutions depends on the type of loan or security. Therefore, the variable interest for the financing of a mortgage is different from those of credit cards or an automobile and others. Additionally, the same is different as banks issue a spread over a benchmark for computing. Also, one’s credit card rating plays a role.

Nevertheless, the variable interest rate charged by financil institutions are mostly benchmaked on the country’s prime interest rate. So, if you are borrowing a loan from a bank or any other financial institution, they will calculate the variable interest rate based on the country’s standard principal or prime rate.

Forms of Variable Interest Rate

Below is a list of items where the variable interest rate is applicable.

 

  • Variable Interest Rate For Credit Cards

 

Besides the variable interest rate on credit cards, there is the annual percentage rate tied to it. The annual percentage rate is based on the principal or prime rate in a country. A credit card interest rate tied to a country’s prime interest rate, only become beneficial to a cardholder if the prime rate decreases. This is because credit card holders will consequently pay less amount of interest on their credit.

The principal rate changes only if the Federal Reserve amends the federal fund rate, which means that the credit card interest charged following the amendment will be affected too either positively or negatively. Unfortunately, cardholders are usually not notified of any changes to the interest rate in advance.  Cardholders and generally all persons are required to be self-aware of their finances by being vigil and looking out for any announcements by the Federal reserves.

Based on the terms and conditions of a credit card, the interest rate is calculated based on the country’s principal rate and an addition of a certain percentage depending on the worthiness of the credit rating of the credit card holder. The Interest amount, on the other hand, is calculated by multiplying the interest rate by the balance you are intended to pay.

The variable interest rate can affect cardholders negatively since the interest tends to fluctuate and the cardholder may, consequently, end up paying more than anticipated.Therefore, it is important that one diligently goes through the terms and condition, agreement and recent statement of your credit card.Another key point to note, when you exceed the period within which you should pay your loan by sixty days, the variable interest rate will be increased.

 

  • Variable Interest Rate Bonds

 

London interbank offered rate (LIBOR) is the principal rate for variable interest rate bonds in the United Kingdom. For American citizens, the key principal benchmark rate variable rate demand bond is the U.S. Treasury bond. The variable bond comes in either five years, ten years or thirty years coupon. The bond is payable on demand upon a change in the interest rate.

 

  • Variable Interest Rate Loans And Mortgages

 

Generally, Variable mortgage loans are paid in monthly installments, and depending on the prime rate, a borrower of a loan may end up paying a larger amount of loan in a certain month as compared to other months due to interest fluctuations. Most mortgage loans have an adjustable interest rate. Nevertheless, one can have a fixed interest rate for the first few years and then the rate will sway depending on several factors affecting the prime rate.

However, most borrowers would still choose a variable interest rate over a fixed interest rate, because it is usually tailored to appear lower in comparison to a fixed interest rate at the time one is making an application for a mortgage. Therefore qualifying for the variable interest rate is easy because it is affordable. Additionally, the monthly payment rate is lower and may be attractive to people who do not expect to live in the house for long.

Disadvantage of Mortgage Variable Interest Rate

It is advisable to understand the complex terminologies of this package before you take mortgage variable interest rate. The terms under which you borrow money are complicated.

There are multiple options to choose from but due to prime rate fluctuating it becomes hard to choose one.

Sometimes interest rate may multiply twice the monthly payment. For example, if you pay fifteen hundred dollars monthly, and the interest rate goes high twice this amount, you have to pay three thousand dollars plus an addition fifteen hundred dollars.

Effects of Variable interest rate

  1. Determine if one borrows loan or not, if the rates are high, then there is less borrowing and the vice is true.
  2. Affects stock trade
  3. Affects the bond market
  4. Determine how much an investor will risk

In conclusion, the Variable interest rate is a complicated case influence by the economies of demand and supply. Therefore, if you are not sure about your financial profile, avoid a variable interest rate.

References for Variable Interest Rate

Academic Research on Variable Rate

An analysis of variable rate loan contracts, Cox, J. C., Ingersoll Jr, J. E., & Ross, S. A. (1980). The Journal of Finance, 35(2), 389-403.

Hedging guarantees in variable annuities under both equity and interest rate risks, Coleman, T. F., Li, Y., & Patron, M. C. (2006). Insurance: Mathematics and Economics, 38(2), 215-228.

The variable rate‐of‐growth effect in the life‐cycle saving model, Fry, M. J., & Mason, A. (1982). Economic Inquiry, 20(3), 426-442.

The bounds of the concentration index when the variable of interest is binary, with an application to immunization inequality, Wagstaff, A. (2005). Health economics, 14(4), 429-432.

Fixed versus variable rate loans, Santomero, A. M. (1983). The Journal of Finance, 38(5), 1363-1380.

Fixed‐and VariableRate Mortgages, Business Cycles, and Monetary Policy, Rubio, M. (2011). Journal of Money, Credit and Banking, 43(4), 657-688.

Incidence of a capital income tax in a growing economy with variable savings rates, Feldstein, M. (1974). The Review of Economic Studies, 41(4), 505-513.

Is the long-term interest rate a policy victim, a policy variable or a policy lodestar?, Turner, P. (2014). Developments in macro-finance yield curve modelling, 19-55.

The VariableRate Mortgage and Risk in the Mortgage Market: An Option Theory Perspective: Note, Findlay, M. C., & Capozza, D. R. (1977). Journal of Money, Credit and Banking, 9(2), 356-364.

Economic feasibility of variablerate nitrogen application utilizing site-specific management zones, Koch, B., Khosla, R., Frasier, W. M., Westfall, D. G., & Inman, D. (2004). Agronomy Journal, 96(6), 1572-1580.

Negotiability and Variable Interest Rates, Hiller, J. S. (1985). Com. LJ, 90, 277.

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