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Variable Interest Rates

By: EconomyWatch Content Date: 4 November 2009

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As opposed to fixed interest rates, variable interest rates are a financing option that allows a consumer to pay a lower rate of interest on a loan or a mortgage. Since the variable interest rate is based on the current national level average, the general economic state can drive down interest rates for extended periods of time. During these periods, the consumer can save a substantial amount from the starting rate of interest associated with the transaction.

Variable interest rates fluctuate with changes in the interest rate index. In declining interest rate markets, variable rates fall in conjunction with the underlying interest index.

Variable Interest Rates: Risks Involved

Variable interest rates carry varying degrees of risks as compared to fixed interest rates. Because the fixed rate of interest will remain constant for the duration of the loan or mortgage, the investor knows how much s/he will pay in interest over the long term. With variable interest rates, this is not the case. The investor may initially pay less interest than indicated at the time of signing the contract 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 have to pay much more in interest over the term of the mortgage or loan.

Other risk factors may include demand and supply, inflation and the Federal Reserve’s influence. When credit demand is high, interest tends to increase at the same pace. Reduced demand for credit decreases the rate of interest. In the same vein, as inflation climbs, interest rates will climb as well. The reasoning behind this is that any money that has been borrowed will have less buying power by the time it is paid back. To cover for this loss, banks raise the fees that they charge for borrowing.

The length of the financing can have an effect on variable interest rates as well. If a loan is extended over a long period of time, such as home mortgage, banks may feel that the risk factor is considerably higher. Greater risks can mean that a lending institution may feel that the fees that it charges should be higher.

Variable Interest Rates: Things to Consider

There are no reliable methods to predict future interest rates. Variable interest rates are suitable for those who can tolerate fluctuations in rates. Interest rates on variable interest rate loans change either monthly or quarterly, depending on the lender. People who prefer to play it safe, fixed interest rates are more suitable. Fixed interest rates mean fixed monthly payments for the life of the loan. The predictability of this loan type can help one manage his/her finances.