Legal Definitions - variable rate

A variable rate refers to an interest rate or payment amount that is not fixed and can change over time. Unlike a fixed rate, which remains constant for the duration of an agreement, a variable rate fluctuates based on an underlying benchmark or index, such as the prime rate, LIBOR (London Interbank Offered Rate), or a specific government bond yield. This means that the amount of interest paid or received can go up or down, impacting the total cost of a loan or the return on an investment.

• Example 1: Adjustable-Rate Mortgage (ARM)

  Imagine a homeowner, Sarah, takes out an adjustable-rate mortgage. Her initial interest rate is low for the first three years, but after that, it adjusts annually based on a widely published market index plus a set margin. If the market index increases, Sarah's interest rate will go up, leading to higher monthly mortgage payments. Conversely, if the index decreases, her payments will fall. This illustrates a variable rate because her interest rate and subsequent payments are not fixed but rather change periodically according to external market conditions.

• Example 2: Student Loan with a Floating Rate

  John has a private student loan where the interest rate is tied to the federal funds rate, adjusting every six months. When the federal funds rate, a benchmark set by the central bank, increases, John's student loan interest rate also rises, making his monthly payments higher. If the federal funds rate drops, his interest rate and payments will decrease. This demonstrates a variable rate because the cost of borrowing for John's student loan is not static but fluctuates in response to changes in a specified economic indicator.

• Example 3: Business Line of Credit

  A small business, "Innovate Tech," secures a line of credit from a bank to manage its fluctuating cash flow. The interest rate on this line of credit is set at "prime plus 2%," meaning it's always two percentage points above the bank's prime lending rate. If the prime rate, which is influenced by the broader economic environment, increases from 4% to 5%, Innovate Tech's interest rate on its drawn balance will automatically increase from 6% to 7%. This is a variable rate because the interest cost for the business's borrowing changes directly with the fluctuating prime rate, rather than remaining constant.