# Variable Interest Rate: Definition, Benefits, Drawbacks, and Comparison to Fixed

## What Is a Variable Interest Rate?

A variable interest rate (sometimes called an “adjustable” or a “floating” rate) is an interest rate on a loan or security that fluctuates over time because it is based on an underlying benchmark interest rate or index that changes periodically.

The obvious advantage of a variable interest rate is that if the underlying interest rate or index declines, the borrower’s interest payments also fall. Conversely, if the underlying index rises, interest payments increase. Unlike variable interest rates, fixed interest rates do not fluctuate.﻿﻿

### Key Takeaways

*   A variable interest rate, unlike a fixed interest rate, changes over time based on an underlying benchmark or index, impacting loan and security payments.  
    
*   Common benchmarks for variable rates include the prime rate and the Secured Overnight Financing Rate (SOFR).  
    
*   While variable rates offer potential cost savings when benchmark rates decline, they pose risks of increased payments if rates rise, challenging predictable budgeting.  
    
*   Variable interest rates are prevalent in various financial products, including mortgages, credit cards, bonds, and derivatives, each with specific mechanisms influencing their rates.  
    
*   Adjustable-rate mortgages (ARMs) often feature initial fixed-rate periods, after which they adjust based on financial markets and predefined margins, introducing budgeting variability over the long term.  
    

## How Variable Interest Rates Work

A variable interest rate is a rate that moves up and down with the rest of the market or along with an index. The benchmark for a variable interest rate [depends on the loan](https://www.investopedia.com/articles/pf/07/loan_types.asp) or security type, commonly tied to SOFR or the [federal funds rate](https://www.investopedia.com/terms/f/federalfundsrate.asp).

Variable interest rates for mortgages, automobiles, and [credit cards](https://www.investopedia.com/average-credit-card-interest-rate-5076674) may be based on a benchmark rate, such as the [prime rate](https://www.investopedia.com/terms/p/primerate.asp) in a country. Banks charge a [spread](https://www.investopedia.com/terms/s/spread.asp) over the benchmark rate, which depends on the asset type and the consumer’s [credit rating](https://www.investopedia.com/terms/c/creditrating.asp). Thus, a variable rate may bill itself as “the LIBOR plus 200 basis points” (plus 2%).

[Residential mortgages, for instance, can be obtained](https://www.investopedia.com/mortgage/mortgage-rates/how-it-works/) with fixed interest rates, which are static and cannot change for the duration of the mortgage agreement, or with a floating or adjustable interest rate, which is variable and changes periodically with the market. Variable interest rates can also be found in credit cards, corporate bond issues, swap contracts, and other securities.

Primarily available in the United Kingdom and some European countries, [tracker mortgages](https://www.investopedia.com/tracker-mortgage-8684434) are variable-rate loans that use a base rate from the Bank of England or the European Central Bank.

> **Important**
>
> Due to recent scandals and questions around its validity as a benchmark rate, LIBOR has been replaced by the Secured Overnight Financing Rate (SOFR). 

## Navigating Variable Rates in Credit Cards

Variable-rate credit cards have an [annual percentage rate](https://www.investopedia.com/terms/a/apr.asp) (APR) linked to a specific index, like the prime rate. The prime rate most commonly changes when the Federal Reserve adjusts the federal funds rate, resulting in a change in the rate of the associated credit card. Variable-rate credit cards can change rates without notifying the cardholder in advancewh.

> **Important**
>
> Variable-interest-rate credit cards can change rates without telling their customers.

Within the “terms and conditions” document associated with the credit card, the interest rate is most commonly expressed as the prime rate plus a particular percentage, with the listed percentage being tied to the creditworthiness of the cardholder.﻿﻿ An example of the format is the prime rate plus 11.9%.

## Exploring Variable Rate Loans and Mortgages

Variable-interest-rate loans function similarly to credit cards except for the payment schedule. Credit cards are revolving credit, but most loans are installment plans with set payments until paid off. As interest rates vary, the required payment will go up or down according to the change in rate and the number of payments remaining before completion.

When a mortgage has a variable interest rate, it is more commonly referred to as an [adjustable-rate mortgage](https://www.investopedia.com/terms/a/arm.asp) (ARM). Many ARMs start with a low fixed rate for the initial years, adjusting after that period. Common fixed-interest-rate periods on an ARM are three, five, or seven years, expressed as a 3/1, 5/1, or 7/1 ARM, respectively. There are also usually adjustment “caps” that put a limit on how much the interest rate can go up or down when it adjusts. You can use an [online calculator](https://www.mortgagecalculator.org/calcs/arm.php) to get an estimate of current interest rates on adjustable-rate mortgages.

In most cases, ARMs have rates that adjust based on a preset margin and a major mortgage index, such as the LIBOR, the [11th District Cost of Funds Index](https://www.investopedia.com/terms/1/cofi.asp) (COFI), or the [Monthly Treasury Average Index](https://www.investopedia.com/terms/m/mtaindex.asp) (MTA Index). If, for example, someone takes out an ARM with a 2% margin based on the LIBOR, and the LIBOR is at 3% when the mortgage’s rate adjusts, the rate resets at 5% (the margin plus the index).

## Delving into Variable Rate Bonds and Securities

Variable-rate bonds may use SOFR as the benchmark. Some variable-rate bonds also use the five-year, 10-year, or 30-year U.S. Treasury [bond yield](https://www.investopedia.com/terms/b/bond-yield.asp) as the benchmark interest rate, offering a coupon rate that is set at [a certain spread above the yield on U.S. Treasuries](https://www.investopedia.com/articles/investing/100814/why-10-year-us-treasury-rates-matter.asp).

Fixed-income derivatives may have variable rates. For example, an [interest rate swap](https://www.investopedia.com/terms/i/interestrateswap.asp) exchanges one set of interest payments for another based on a specified principal. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates—or to obtain a marginally lower interest rate than would have been possible without the swap. A swap can also involve the exchange of one type of floating rate for another, which is called a [basis swap](https://www.investopedia.com/terms/b/basisrateswap.asp).

## Weighing the Pros and Cons of Variable Interest Rates

Pros

*   Variable interest rates are generally lower than fixed interest rates.
    
*   If interest rates go down, the borrower will benefit.
    
*   If interest rates go up, the lender will benefit.
    

Cons

*   Variable interest rates can go up to the point where the borrower may have difficulty paying the loan.
    
*   The unpredictability of variable interest rates makes it harder for a borrower to budget.
    
*   It also makes it harder for a lender to predict future cash flows.
    

> **Article Sources**
>
> 1.  Corporate Finance Institute. "[Floating Interest Rate: What Is a Floating Interest Rate?](https://corporatefinanceinstitute.com/resources/knowledge/finance/floating-interest-rate-variable/)" Accessed Aug. 17, 2020.
>     
> 2.  Corporate Finance Institute. "[Floating Interest Rate: Use of Floating Interest Rate](https://corporatefinanceinstitute.com/resources/knowledge/finance/floating-interest-rate-variable/)." Accessed Aug. 17, 2020.
>     
> 3.  Corporate Finance Institute. "[Floating Interest Rate: Uses of Floating Interest Rate](https://corporatefinanceinstitute.com/resources/knowledge/finance/floating-interest-rate-variable/)." Accessed Aug. 17, 2020.
>     
> 4.  Debt.org. "[How is Credit Card Interest Calculated?: Variable Interest Rates](https://www.debt.org/credit/cards/interest/)." Accessed Aug. 17, 2020.
>     
> 5.  Freddie Mac. "[How it Works: Adjustable Rate Mortgages (ARMs)](http://www.freddiemac.com/blog/homeownership/20160201_hiw_arm.page?)." Accessed Aug. 17, 2020.
>     
> 6.  U.S. Securities and Exchange Commission. "[Floating-rate Bond (or Variable or Adjustable rate Bond)](https://www.investor.gov/introduction-investing/investing-basics/glossary/floating-rate-bond-or-variable-or-adjustable-rate)." Accessed Aug. 17, 2020.
>     
> 7.  Corporate Finance Institute. "[Interest Rate Swap](https://corporatefinanceinstitute.com/resources/knowledge/finance/interest-rate-swap/)." Accessed Aug. 17, 2020.