What Are Variable Interest Rates?

As much as there are different kinds of loans in the market, they all have a common feature which is interest. When you borrow money from a lender, you pay back what you borrowed plus interest. Note that interest is paid on the amount you borrow and not on the purchase price. Typically the average interest rates on car loans is set at almost 5% all the  way to 17%, therefore, it important to know what the best suitable interest rates will suit your current situation as some loans may have a low interest rate but they may have hidden costs that may lead you to paying more over the years. There are two types of rates and in this article we will be discussing one of them known as a Variable Interest Rate. 

What is a Variable Interest Rate?

A variable interest rate also sometimes referred to as an adjustable or floating rate is an interest rate on a loan that fluctuates over time in accordance with market conditions and lender’s policies. It is tied to a benchmark interest rate known as an index. When the index changes, the interest rates may change as well, also causing the borrower’s monthly repayments to change. The underlying benchmark interest rate for a variable interest rate depends on the type of loan or security but it is frequently linked to the federal funds rate.  Typically, a variable interest rate will start relatively low as a way to entice a customer to choose a particular over the others who might initially charge more. Variable interest rates can be risky as they are liable to increase with inflation.

When it comes to car loans with variable interest rates, there are two main loan types; Unsecured car loans and Secured Car Loans. Unsecured car loans are loans where the lender does not need an asset to act as security whereas for secured car loans the lender will need you to give up an asset that will act as a guarantee. If you fail to make your repayments as agreed, the lender has the right to possess your asset. When taking out variable car loans, avoid long term loans. The longer you stay paying out these loans, the higher the risk of the interest rates going up. 

Other financial products that come with variable interest rates include credit cars, auto loans, private student loans and adjustable rate mortgages. For these products, the variable interest rates may be based on a benchmark rate such as the prime rate in a country.

What are the reasons behind variable rates changing?

Firstly, the Reserve Bank of Australia (RBA) is easily one of the biggest factors that influence how often variable rates move because any change the RBA makes to the official cash rate impacts the lender’s wholesale funding costs which are then passed onto you as the borrower. They are in charge of setting the official cash rate every month. When the official cash rates fall, the interest rates go low and when they rise, the interest rates rise as well. 

Secondly, banks need to make sure they have a high return on equity (ROE). ROE is basically a measure of how efficiently shareholder money is being used for profit for the banks. Hiking up interest rates raises the amount of profit a bank makes and more profit means making the shareholders happy. When you lower the interest rates, customers benefit while the shareholders not as much. Last but not least, regulatory changes can also impact variable rates.

How to compare variable rate loan options

Considering some of these factors could help you select the best variable rate loan option for your current situation.

• Get to know what interest rates you will be charged. As much as the rate is variable, looking at the rate when comparing will give you an idea of the competitiveness of the product.
• Keep an eye out for upfront fees and ongoing fees such as monthly and annual fees.
• Check whether you are able to make lump sum payments or additional repayments.
• Last but not least, when comparing, inquire whether you can repay the loan early or terminate it without having to pay a fee.

Pros and cons of variable interest rates

Apart from the above mentioned factors, knowing the pros and cons of these interest rates is important as they may help you determine whether it’s the right choice for you.

Pros;

• If interest rates go down, you as the borrower may benefit
• If the rates go high, the lender may benefit
• They are flexible in terms of allowing additional repayments

Cons;

• The unpredictability of variable interest rates might make it hard for the borrower to budget
• On the other hand, for the lender it might make it hard for them to predict future cash flow
• For the borrower, the rates may go up so high to the point where one has a hard time repaying the loan

 

Read more: Car Lease Vs Hire Purchase. What Is The Difference?