Variable Interest Rate
A variable interest rate is, in the broadest sense, an interest rate that is not fixed but can be changed. In practice, variable interest is used for both investments and loans. The exact design always depends on the terms agreed for the specific individual case or that apply to a certain category of investment or loan products.
Different Forms of Variable Interest Rates
Without further clarification, "variable" in this context only means that the initial interest rate does not have to remain constant for the entire term of the investment or loan, but can be changed by the lender at any time. However, this aspect is often specified in more detail, for example by the contracting parties agreeing that an adjustment of the interest rate is only possible if certain conditions are met—such as a change in a specific reference rate.
Such reference rates include, for example, the Euro InterBank Offered Rate, often abbreviated as EURIBOR, or the LIBOR (London InterBank Offered Rate); in Germany, the FIBOR (Frankfurt InterBank Offered Rate) was also frequently used in the past. It can be agreed, for instance, that an adjustment of the investment or loan interest will take place if the reference rate has changed by a certain percentage.
Alternatively, it is also possible that the interest rate is adjusted at certain dates to reflect changes in the reference rate without a separate decision being required each time. Whether changes in the reference rate are passed on 1:1 or only partially can again be handled differently case by case.
It should also be distinguished between cases in which an adjustment of the interest rate must necessarily take place and those in which the bank simply has the discretion to adjust the interest rate or to refrain from doing so.
Variable Interest Rate versus Fixed Interest
Whether a variable interest rate or a fixed interest rate is preferable can only be assessed with regard to the borrower's or investor's individual situation. From an investor's point of view, who decides on a particular savings product in a low-interest phase, it certainly makes sense to agree on a variable interest rate. This protects them from continuing to receive only a low return on their deposit in the event of rising market interest rates and thus not participating in the increase in rates.
Conversely, in periods of high interest rates it is more attractive to make investments with a fixed interest rate, because a variable rate would then carry the risk of possibly yielding a lower return at some point than at the start.
From a borrower's perspective, the situation is exactly the opposite. It is more attractive for them to agree on steady loan interest rates for as long as possible during a low-interest phase in order to secure the relatively low interest burden for as long as possible. In high-interest phases, a variably interest-bearing loan is more sensible because it at least offers the chance that the burden for debt service will also decrease in the event of a falling interest level.
Pricing and Interest
However, it should be noted that the advantages and disadvantages of the different interest variants are usually already reflected in the design of the terms. For example, in low-interest phases, loans with variable interest are often offered slightly cheaper than those with a long fixed-interest period, where any interest advantage is at least partially offset by a certain surcharge.
Someone who—for example, when taking out a mortgage—agrees on a fixed interest period of ten, fifteen, or more years therefore has to pay slightly higher interest than someone who fixes their rate for only five years. On the other hand, the higher interest buys greater planning security over a longer period, while the interest savings from a short fixed-rate period can be more than offset by the fact that significantly higher interest may be due once that period expires.
Practical Market Significance of Loans with Variable Interest Rates
In Germany, a variable interest rate is quite commonly used in retail banking for current accounts, credit card accounts, overdraft and disposal credit facilities, whereas long-term loans such as mortgage financing or longer-term consumer loans are comparatively less often agreed purely with variable interest.
However, this is by no means the case in all countries. In the USA, for example, loans with variable interest rates are much more widespread, including in the mortgage business. The advantage is that the credit market "breathes" more—that is, rate cuts tend to lead to a stronger expansion of lending in the market, while rate increases more sharply dampen credit demand.
But there are also specific risks, which became particularly apparent during the financial crisis in 2007 and 2008 in the USA. In particular, the fact that temporarily low interest costs had encouraged many borrowers to take on debt who, with a relatively small rise in rates, were no longer able to cover the amounts required for debt service, proved to be a serious problem with consequences for the entire US economy and beyond.
Conversely, the fact that variable-rate loans are used to a much lesser extent in Germany is often cited as one reason why Germany did not experience problems even remotely comparable to those in the US mortgage market.
Floating-Rate Bonds
Another area in which a variable interest rate is used is so-called floaters—also referred to as floating rate notes or abbreviated as FRNs. These are bonds with variable interest. In a floater, the interest is usually linked to a specific reference rate, such as the EURIBOR or the LIBOR. In addition, there are other securities with variable interest rates that are not called floaters but are classified as structured products.
With floaters, the purchaser of the security essentially acts as a lender who receives a variable interest rate from the issuer and possibly credit-related premiums or discounts. It is common, for example, to set the interest rate for the next coupon at the time of paying a coupon. For an investor deciding between a fixed-rate and a variable-rate bond, the same considerations apply as for the savings products mentioned at the beginning.