What is a Variable Interest Rate?

When you borrow money through a loan or pay off a credit card balance, you’ll typically owe interest which is the cost of borrowing. Sometimes the interest rate you pay will stay the same, which is called a fixed interest rate. In other cases, the interest rate can go up or down over time, which is known as a variable interest rate. A variable interest rate is typically based on the current market rate and the account terms set by your lender. In general installment loans have fixed interest rates, and credit cards, lines of credit and adjustable-rate mortgages (ARMs) have variable interest rates.

Comparing financing options or managing debt can seem confusing when your interest rate changes. Let’s explore how variable interest rates work and how they compare to fixed interest rates so you can better understand your borrowing costs.

What is a variable interest rate?

A variable interest rate, also known as an “adjustable” or “floating” rate, can increase or decrease over time.¹ Unlike a fixed interest rate which stays the same for the duration of the loan or line of credit, a variable rate changes according to the terms of your agreement. When the interest rate goes up, you’ll pay more in interest, and when the interest rate goes down, you’ll pay less. Variable interest rates are often found on credit cards, lines of credit and ARMs.

Why do variable interest rates change?

One of the main reasons a variable interest rate changes is because some lenders tie their variable-rate credit products to the federal funds rate — the target rate that banks use to borrow and lend money to one another.² The federal funds rate is set by the Federal Reserve System (the Fed) which is the central bank of the United States.³

Lenders, banks and credit unions set their own interest rates. But they also consider the current market rate, what competitors are charging, state and federal laws, and any policies or limits the Fed has set. For example, when the Fed raises the federal funds rate, borrowing generally becomes more expensive which can cause variable interest rates on credit cards or loans to rise.

How does a variable interest rate work?

Variable interest rates are usually tied to an index — a standard rate that changes with market conditions. Lenders may add a margin, a fixed percentage set in your account agreement, on top of the index. Together the index and margin make up your total interest rate. For example, if an index interest rate is 3% and your loan agreement includes a 2% margin, your interest rate would be 5%. The index and margin are described in your account agreement.

ARMs also include rate caps which are limits on how much a rate can change on a single adjustment over the life of the loan. A rate cap can help protect borrowers from drastic payment hikes due to rising rates. However, rates may be higher than standard market fixed rates.

How variable interest rates affect different types of borrowing

Variable interest rates can affect the amount you pay each month whether you’re using a credit card, drawing from a line of credit or making mortgage payments on an ARM. How much your payments change depends on the type of borrowing and the terms of your agreement. The following examples show how variable rates work across different types of borrowing:

• Credit cards: A credit card is a type of revolving credit that allows you to borrow funds up to a certain limit, repay and borrow again. Most credit cards have variable interest rates. The annual percentage rate (APR) — the annual cost of borrowing including interest and fees — is tied to an index. If the index goes up, issuers can adjust the interest rate on your credit card without additional notice which can cause your monthly payment to rise if you carry a balance.⁴
• Lines of credit: A line of credit lets you borrow money as needed, up to a set limit, for a specific period. Examples include personal lines of credit and home equity lines of credit (HELOCs) which allow you to borrow against the equity in your home. You only pay interest on the money you use, but a variable interest rate can make it harder to predict how much you’ll owe. Because lines of credit are revolving, the balance you carry and how often you borrow also impact how much interest you pay.⁵
• ARMs: While many traditional mortgages have fixed interest rates for the life of the loan, ARMs start with a fixed rate for a set period that can last anywhere from one month up to 10 years.⁶ After the initial fixed period, the interest rate becomes variable and adjusts on a schedule — although the rate cap limits how much it can go up. The new rate is tied to a market index plus a margin.

Variable vs. fixed interest rate

Variable interest rates can change over time, while fixed interest rates stay the same for the life of a loan or line of credit. Fixed interest rates may be easier to manage, but variable interest rates are usually lower at the start of the term.⁷ Understanding the differences can help you decide which type of interest rate works best for your borrowing needs.

Feature	Variable interest rate	Fixed interest rate
Interest rate	May change based on the terms of the account agreement	Is set according to the terms of the account agreement
Adjustment schedule	Changes either on a set schedule (monthly, yearly, etc.) or with advance notice	No adjustments
Rate caps	May include limits on how much the interest rate can increase at a given time or overall	Maximum rate may be limited by state law or lender policy
Most common uses	Credit cards, lines of credit, ARMs	Personal loans, traditional mortgages, auto loans
Benefits	Short-term savings if the initial rate is lower, potential for reduced payments if market rates fall	Long-term predictability for payments
Risks	Your rate may get higher as market rates change	If market rates fall, you’ll be locked into a higher interest rate

Pros and cons of variable interest rates

Any time you look for financing or credit, it’s important to understand the pros and cons so you can figure out what’s best for your situation. A variable interest rate can have advantages over a fixed rate, but it can also have some drawbacks.

Pros

• Lower initial rates: Variable interest rates often start off lower than the market rate.⁸ You can save money upfront and reduce your overall interest charges if you plan to pay off your balance quickly.
• Potentially lower payments: If market rates go down, your monthly payments may decrease automatically.
• Promotional offers: Some credit offers may feature a temporary promotional 0% APR which means you’re not charged interest on certain types of transactions for a set amount of time. When the promotional period ends, a higher variable interest rate will go into effect.

Cons

• Potentially higher payments: If market rates increase, you may have to make larger monthly payments.
• Unpredictability: The interest rates on credit cards and lines of credit may change without notice. For ARMs, you’ll be notified of upcoming changes, but you won’t know how much your rate will change when at the beginning of the loan.
• Potentially higher overall costs: Depending on how the market changes, you may end up paying more with a variable interest rate than you would with a fixed interest rate.

If credit with a variable interest rate isn’t right for you, you might consider a financing option with a fixed rate, such as a personal loan. A OneMain personal loan offers a fixed interest rate and predictable monthly payments with funds made available as soon as one hour after loan signing.^†

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Know your options before you borrow

When you’re looking for financing, you’ll likely encounter both fixed and variable interest rates. Some kinds of loans and credit may only offer one option or the other. Understanding how both kinds of interest rates work can help you make the best borrowing choices for your needs.

Sources

1, 4, 7, 8 https://www.investopedia.com/terms/v/variableinterestrate.asp
2, 3 https://www.investopedia.com/terms/f/federalfundsrate.asp
5 https://www.experian.com/blogs/ask-experian/what-is-a-line-of-credit/
6 https://www.investopedia.com/mortgage/mortgage-rates/fixed-versus-adjustable-rate/