Variable interest rate: Should you get one?

Interest rates affect the real estate market by influencing home prices, mortgage costs, and buyer demand. Lower rates make borrowing cheaper, driving prices up, while higher rates slow sales by making loans more expensive. One option is a variable interest rate, which fluctuates with the market. But is it the right choice for you? Let’s take a closer look.

What is a variable interest rate?

A variable interest rate changes over time, unlike a fixed rate that stays the same for the life of a loan. This type of rate is tied to a market index — like the prime index rate — and will rise or fall based on market conditions. Some loans have limits on how often the rate can change and how high it can go.

Many financial products have variable interest rates, including credit cards, private student loans, home equity lines of credit (HELOCs), and personal loans. While they’re less common for mortgages, some borrowers choose adjustable-rate mortgages (ARMs), which start with a lower fixed rate for a set period before switching to a variable rate.

A variable interest rate can be beneficial for mortgage interest rates if you expect rates to stay low or plan to pay off the loan before rates increase. However, there’s always a risk that rates will rise, making payments more expensive over time. Understanding how these changes work can help you decide if a variable-rate loan fits your financial goals.

How do variable interest rates work?

A variable interest rate changes over time based on the index your mortgage lender follows. This means your monthly payments can increase or decrease depending on how the index moves.

Lenders use different indexes to set variable rates, and each one reacts differently to market conditions. Below are some common indexes that may determine your interest rate.

LIBOR index

LIBOR, or the London Interbank Offered Rate, was a key benchmark for interest rates on financial products worldwide. While financial institutions no longer use it for new loans, some older loans may still be tied to it. In 2023, LIBOR was officially replaced by the Secured Overnight Financing Rate (SOFR) as the new standard.

Prime rate

The prime rate is the lowest interest rate a bank offers and is typically reserved for borrowers with strong credit. It relies on the federal funds rate set by the Federal Reserve and tends to follow its movements closely. Lenders often use the prime rate as a benchmark to set mortgage rates, credit card rates, and other loan terms, impacting many financial products.

Federal Cost of Funds Index (COFI)

The Federal Cost of Funds Index (COFI) is used as a reference point for certain types of mortgages and securities. It’s calculated by averaging the monthly interest rates for Treasury bills and notes, then dividing by two and rounding to three decimal places. Freddie Mac typically releases this index around the 20th of each month for use by lenders and financial institutions.

How are variable interest rates different?

Variable interest rates change based on market conditions, while fixed rates stay the same throughout the loan term. Floating rates, like variable rates, adjust with the market, but typically follow a specific benchmark.

• Fixed: A fixed interest rate remains constant for the entire term of the loan. Your monthly payments will stay the same, giving you stability and predictability over time.
• Floating: A floating interest rate, like a variable rate, is tied to a financial index and can change based on market conditions. However, the adjustments might occur less frequently, and the rate may be more predictable over time than variable rates.

Pros and cons of variable interest rates

Understanding the pros and cons of variable interest rates can help you decide if they're the best option for you.

Should you get a variable interest rate?

Variable interest rates are less stable than fixed-rate loans but can be a good option for some home buyers. For instance, an ARM can save you money if you plan to move within a few years or can pay off the mortgage quickly. However, if you're buying a forever home, the shorter loan terms may not be as beneficial in the long run.

The bottom line: A variable rate can be a good option for your mortgage

Choosing a mortgage with a variable interest rate may seem risky, but it can be a great option if you want to pay less interest over time. A variable-rate loan could save you money if you plan to move in a few years or pay off your loan early, or if you expect interest rates to stay low.

To learn more about the benefits of variable interest rates, get approved today for an adjustable-rate mortgage. You could qualify for an ARM with Rocket Mortgage® if you have a credit score of 620 or greater.