Variable rate loans, which have increasing or decreasing payments depending on prevailing interest rates, scare people. The metaphorical boogieman of potentially higher payments some day in the future drives most to flock to the perceived peace of mind of fixed rate loans. What we’ll explore in this article is the monetary cost of that certainty, and how a variable loan may actually be better for you versus a fixed rate loan.
The Variable Rate Discount
Since fixed rate loans are perceived as riskier to a lender’s profitability (they’re promising not to increase your payments for 30 years in some cases!), the interest rates on fixed rate loans are normally higher than variable rate loans. Below is an example using the rates for a 30-year fixed rate mortgage versus adjustable rate mortgages.
Source: St. Louis Federal Reserve, Freddie Mac
With an average variable rate discount of 0.68%, a borrower would save about $40 each month for every $100,000 borrowed versus a 30-year fixed rate mortgage, assuming rates were unchanged.
This idea of a discount on variable loans versus fixed loans is nearly universal. See the table below for another example using student loan rates with Laurel Road in 2021. Note how much less variable rate loans are compared to fixed loan rates, especially at shorter loan terms.
The conclusion is that the certainty of a fixed payment with any loan comes at a cost and you may be able to save money by choosing a variable rate loan. Below we’ll discuss some specific situations which may make variable rate loans more appealing.
Scenario #1 – What You’re Buying Increases & Decreases with Inflation
You’ve experienced the effects of inflation before if you remember when a stamp cost less than 40 cents, or when gasoline cost 80 cents a gallon. Inflation is a general rise in the price of everything, and it is highly correlated to interest rates overall. The chart below shows the annualized change in the Consumer Price Index (inflation) versus the 3-month London Interbank Offered Rate (LIBOR), which is typically the benchmark rate used for setting variable rate loan payments.
Source: St. Louis Federal Reserve
Therefore, if you are buying an asset which increases in value when prices are generally rising and you can take cash from that asset via a line of credit to make higher payments should interest rates increase, you should choose a variable rate loan. Such types of assets often include real estate, some commodities like gold and silver, and stocks. Assets which don’t experience this characteristic are motor vehicles, bonds, and household furnishings.
Why wouldn’t you just apply for a fixed rate loan again? Well, besides the fact that you’re going to pay extra for the certainty of a fixed rate loan, consider a worst-case scenario which actually occurred. In 2008, interest rates fell and home prices also fell. Consumers with fixed rate mortgages had to make the same payments as before even though rates were lower or they would fork over thousands of dollars to refinance their loans. For those curious, the average cost of a mortgage refinance is 2-3% of a mortgage’s value, according to Rocket Mortgage.
Scenario #2 – Your Income is Highly Cyclical
Variable rate loans are great for someone who has an income closely linked to economic conditions. In these cases, you can save money with the variable rate discount but you get the added bonus of having your payments increase or decrease along with your income.
Here’s an example. The owner of an entertainment company has a fixed rate loan at 6.00% for his warehouse and equipment. When the economy is strong, he has more customers hosting parties, weddings, and other events. He feels wealthy because his loan payment is the same, but his income is rising because of strong business.
Now let’s assume the opposite scenario. The economy takes a downturn and the owner now has very few customers. Even though interest rates have declined, as they often do during economic recessions, his monthly payment is still the same. He is faced with a declining income, but his expenses are the same. Depending on how bad business is, he may not be able to make his payments.
In this example, the business owner would have been better off with a variable rate loan, as his falling income during bad economic times would most likely have been accompanied by falling interest rates, meaning his expenses would also decrease. Moreover, his initial interest rate would have likely not been 6.00%, but closer to 5.00% or 5.25%.
And just to be clear, interest rates, almost without exception, fall during recessions. The chart below shows gross domestic product versus LIBOR (interest rates).
Source: BEA, St. Louis Federal Reserve
Therefore, if you have a widely fluctuating income a cyclical industry such as entertainment, finance, energy, personal services, or manufacturing, variable rate loans may be more appropriate for you. If you have a stable job with a very stable income (I’m looking at you, healthcare and utility company workers), you may be better off with a fixed-rate loan.
Scenario #3 – The Mortgage Rate Has a Lock
This is a no-risk, win-win for people who purchase a home but don’t intend on living there too long. Most adjustable rate mortgages have a period toward the beginning of the loan when the rates and required payments don’t change. This period is normally five or seven years. Therefore, if you don’t plan on staying at a home for the long-run then you can take advantage of the variable rate discount without ever needing to worry about your rate going up.
If I use the average discount of 0.68% from the first graph in this article and move out of a home exactly seven years after purchasing it, I save close to $13,500 in interest on a $400,000 loan by choosing an adjustable rate mortgage with a seven year lock (often called a “7/1 ARM”) over a traditional 30-year fixed rate mortgage. For this reason, I usually recommend ARMs for young professionals, since they tend to move from place to place due to job and family changes frequently.
Don’t Fear the Variable Boogieman
Variable rate loans got a bad reputation when they became mainstream because they were abused. People took out variable rate mortgages without understanding them. Like most financial instruments, there are specific times when variable and adjustable rate loans are powerful, money-saving instruments and other times when they are not. Some of these scenarios favoring variable rate loans were highlighted above. If you are making a large purchase and would like some guidance as to what type of loan would be best for you, consider calling a financial planner to help crunch the numbers for you. If he or she is skilled at loan analysis, you might save thousands, or even tens of thousands of dollars.