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Variable-rate loans offer the flexibility of keeping up with changing market conditions. Instead of having a set interest rate for the entire term of the loan, the rate changes periodically. While this is a big benefit when rates fall, because your loan's rate drops without having to refinance, it hurts you if interest rates rise. Knowing how the loan's interest rate works can help you decide if it's right for you or how to budget for future changes.
The formula for figuring your new interest rate on a variable-rate loan is to add the interest rate index to your margin. The interest rate index is a measure of the current market interest rate, such as the Cost of Funds Index or the London Interbank Offered Rate (LIBOR). The margin, on the other hand, is specific to your loan. It's set when you take out the loan and is based on your creditworthiness as a borrower. It won't change later on whether your credit gets better or worse.
Each variable-rate loan has a specific time period for calculating the new interest rate. This period varies from loan to loan and could be monthly, every six months, once per year or even less frequently. Some loans keep the initial rate for a longer period before changing. For example, a 5/1 variable-rate mortgage keeps the initial rate for five years and then adjusts the interest rate once per year after that.
Interest Rate Caps
Some loans have various forms of interest rate caps, which limit how much the rate can increase. For example, adjustable-rate mortgages often have a periodic cap, which restricts how much the interest rate can rise or fall each time it adjusts, or a lifetime cap, which limits how much the loan can ever change from the initial interest rate. Also, some student loans simply have maximums that the interest rates can't exceed.
Some variable-rate loans also have payment caps, which limits how much the payment can change. However, these caps can be dangerous to unsuspecting borrowers because when the interest rate increases but the payment doesn't, less of the payment goes to actually paying down the balance. Worse, if the interest due exceeds the payment cap, the extra interest could be added to the amount you owe on the loan. For example, say your loan has a payment cap of $1,500. But because interest rates have risen so much, the interest alone now costs $1,550 per month. If you only pay $1,500, that extra $50 adds to the balance on your loan.
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