Variable Interest Rate: Should You Get One?
September 22, 2023 4-minute read
Author: Jamie Johnson
With the recent increases in mortgage rates, many borrowers are seeking alternative ways to finance a home. If you’re looking for opportunities to save money on interest, you might consider choosing a variable interest rate loan.
When you take out an adjustable-rate mortgage (ARM), you’ll receive a low introductory rate, which will reduce your monthly payments. Once the introductory period is up, your interest rate may rise or fall depending on what happens in the market. This periodic change makes the interest rate variable.
What Is A Variable Interest Rate?
A variable interest rate is an interest rate that changes over time, as opposed to fixed interest rates that remain unchanged over the life of a loan. A variable interest rate is dependent on changes to the index — like the prime index — and will increase or decrease depending on market fluctuations.
Some loans may set guidelines around how often interest rate changes can happen, and there may be a cap on how high your interest rate can rise. Credit cards, private student loans, home equity lines of credit (HELOCs) and personal loans typically come with variable interest rates.
Variable interest rates are a less popular choice for mortgage interest rates. Fixed-rate mortgages tend to be safer for most borrowers, but variable rates can be a good choice depending on your circumstances.
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How Variable Interest Rates Work
A variable interest rate will change periodically depending on the index your lender uses. That means your payments will go up or down, depending on what happens with the index. Listed below is an overview of some common indexes your lender may use.
LIBOR stands for London Interbank Offered Rate and it’s a benchmark interest rate for financial instruments traded on global financial markets. The LIBOR index has been phased out for new loans, but older loans may still be based on this index. The LIBOR index has been replaced by the Secured Overnight Financing Rate (SOFR).
The prime rate is the best possible interest rate a bank is willing to give you, and it’s reserved for creditworthy borrowers. The Federal Reserve sets the federal funds rate, and it serves as the basis for the prime rate. The prime rate is a common benchmark used by lenders to set the rate for mortgages, credit cards and other lending products.
Federal Cost Of Funds Index (COFI)
The Federal Cost of Funds Index (COFI) is used as a benchmark for some mortgages and securities. It’s calculated by taking the sum of the monthly average interest rates for Treasury bills and notes, divided by two and rounded to three decimal places. It’s made available by Freddie Mac on or about the 20th day of each month.
Variable Vs. Fixed Interest Rates
When you’re applying for a home loan, one of the first things you need to decide is whether you’ll take out a fixed-rate versus adjustable-rate mortgage. The type of interest rate you choose will determine how much you pay over the life of the loan.
Unlike variable interest rates, fixed-rate loans don’t change over the life of the loan. The interest rate you receive the day you close on your home will stay the same unless you refinance.
Since your monthly principal and interest payments won’t change, you’ll always know what your monthly payments will look like. Fixed-rate mortgages are usually taken out as 15-year or 30-year loan terms.
In comparison, an adjustable-rate mortgage (ARM) comes with a low introductory rate. This introductory rate is usually lower than what you’ll get with a fixed-rate loan, and it’ll last for a set period of time. For example, if you have a 5/1 loan, your introductory rate will last for 5 years and then adjust every year thereafter.
Variable Vs. Floating Interest Rates
A variable interest rate is also sometimes referred to as a floating interest rate because it rises and falls with the market or benchmark interest rate. Floating interest rates can be adjusted quarterly, semi-annually or annually.
Pros And Cons Of Variable Interest Rates
Variable interest rates sometimes get a bad rap because they’re less stable than fixed-rate loans. However, an adjustable-rate mortgage may be an affordable option for certain types of home buyers.
If you plan to relocate in a few years, taking out an ARM could end up saving you money on interest payments. It may also make sense if you plan to pay off your mortgage before the introductory period is up.
If you’re comfortable with the risks, choosing a variable interest rate could benefit you financially. However, the introductory rate won’t last forever, and an ARM may not be the best choice if you’re trying to buy your forever home.
Familiarizing yourself with the pros and cons of variable interest rates will help you determine the best choice for your situation.
Variable Rate Benefits
Variable Rate Drawbacks
It comes with a low introductory rate.
You may pay more in interest over the life of the loan.
Your mortgage payments will be lower during the introductory period.
Your payments will fluctuate after the introductory period is up, making it harder to budget.
You’ll pay less on your mortgage if interest rates drop.
Your mortgage payments will increase if interest rates rise.
ARMs are often easier to qualify for.
These loans can be more complex and harder to understand than fixed-rate loans.
The Bottom Line: A Variable Interest Rate Can Be A Good Option For Your Mortgage
Choosing a variable interest rate on your mortgage can feel risky, but it may be a good option for borrowers looking to pay less in interest charges. If you know you’re going to move in a few years or plan to pay off the loan early, a variable rate loan can help you save money.
If you want to learn more about the benefits of variable interest rates, you can apply for an adjustable-rate mortgage. If you have a credit score of at least 620, you could qualify for an ARM with Rocket Mortgage®.
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