What is a Variable Interest Rate?

A variable interest rate is an interest rate that changes over time, typically in relation to an underlying benchmark, such as the prime rate. Thus, if the underlying benchmark declines, a borrower is charged a lower interest rate, with the reverse occurring if the benchmark increases. Variable interest rates are commonly applied to credit card debt and other forms of short-term debt.

Advantages of Variable Interest Rates

Lenders tend to set the initial interest rate on a variable rate loan quite low, in order to attract borrowers. This can work out quite well for a borrower when the expected repayment period is quite short, since the loan will not be outstanding long enough for very many rate increases to be applied to the loan. The result is a reasonable average interest rate over the (hopefully) short span of the loan.

Disadvantages of Variable Interest Rates

Variable interest rates present several disadvantages for borrowers, which include the following:

Uncertainty. Payments can increase unexpectedly if interest rates rise, making the budgeting for interest payments difficult.
Default risk. Variable interest rates can be dangerous for a highly-leveraged business, since a jump in the underlying benchmark can make it difficult for the firm to make its scheduled interest payments. They are a particular concern when applied to mortgages, since a borrower will be at risk of a significant rate increase over the multi-year term of the loan.
Market dependency. Variable rates are influenced by external factors like inflation, central bank policies, and economic conditions. Borrowers have no influence over these factors.
Impact on creditworthiness. If rising interest rates make it harder to keep up with payments, borrowers risk missed payments and lower credit scores.