When you are in the real estate market, the type of loan that you choose is arguably just as important as the type of home you select. Most lenders offer a choice between a fixed rate, which locks in the current interest rate, and a variable rate, which fluctuates according to a benchmark index. Let’s look a bit closer at variable home loans.
What is a Variable Rate Loan?
Variable-rate loans are defined by their interest rates that adjust over time in relation to market fluctuations. Most loans that can be structured with a fixed rate are also available with a variable rate, including mortgages, student loans, and personal loans. Car loans are not generally offered at a variable rate, although some specialized lenders will occasionally offer them.
With variable home loans, the interest rate fluctuates throughout the life of the loan. The rate is determined by the lender and based on benchmark indexes, not the Reserve Bank of Australia. While lenders generally follow market conditions, the changes to the cash rate do not necessarily dictate the direction of the interest rate on these loans.
How do Variable Loans Work?
Variable-rate loans are tied to a benchmark rate based on the London Interbank Offered Rate (LIBOR) or the Prime Rate, which gives financial institutions a standardized method of pricing money. These baseline rates pus a margin is used to calculate the consumer’s interest rate on a variable loan. The calculated rate depends on the consumer’s credit score, the lender, and the type of loan. Margins are higher for risky loans, short-term loans, and borrowers with credit issues.
How are Variable Loans Structured?
Borrowers can choose from several structures of variable rate loans, depending on their personal preferences, financial situation, credit score, and lender offerings.
- The variable interest rate for the entire loan. This is based on the benchmark indexed rate plus a margin set by the lender.
- The adjustable-rate that combines fixed and variable rates. This type of structure generally includes an introductory period with a fixed rate before the rate begins to adjust according to market variations. The 5/1 adjustable rate requires payment of a fixed interest rate for the first five years and a variable rate that resets each year based on the benchmark index on that date.
The risk of variable loans might discourage some borrowers, so many lenders include a ceiling on the variable rate that limits that risk. This cap is usually set at a high level, so it doesn’t offer complete protection against market volatility, but it does provide a minimal degree of security. For most variable-rate mortgages, there are three separate rate caps: the initial cap sets a maximum amount that the rate can initially change; the periodic cap determines the amount the rate can vary during each adjustment period, and the lifetime cap fixes the maximum level of a rate increase.
Why Choose a Variable Rate Loan?
The best variable home loan is usually more flexible than a fixed-rate loan, so you are typically allowed to make extra repayments and take advantage of features like offset accounts, which allow you to lower the interest charged by offsetting a credit balance against your home loan debt.
Variable loans typically carry a lower starting interest rate than fixed-rate loans, partially because they are a riskier option for consumers. Rising interest rates can significantly increase the total borrowing cost, and consumers who choose adjustable loans should consider the potential for inflated loan costs if rates should rise. However, for borrowers who can afford the risk, or for those who plan to pay off their debt quickly, variable rates offer an attractive option. These lower rates contribute to lower monthly payments, allowing borrowers to potentially finance for a shorter period of time and build equity more quickly.
Variable loans are preferable when future interest rates are expected to fall. With the best variable interest rates, borrowers benefit from a decrease in dropping benchmark values, causing the rates on their loans to decrease as well. When these loans are structured to include a cap on the variable rate, borrowers are shielded from the worst effects of rising rates.
Ultimately, there are benefits and risks to any type of loan that you choose. Research your options and choose the loan that will be most advantageous to your financial situation, lifestyle and goals.