Definition of a Variable Interest Rate

A variable interest rate is an interest rate that fluctuates based on changes in a benchmark rate, such as the Bank of Canada’s policy interest rate or a financial institution’s prime lending rate. Unlike fixed interest rates, variable rates can increase or decrease over time, impacting loan payments and investment returns.

For example, a Canadian homeowner with a variable-rate mortgage may see their monthly payments rise if the Bank of Canada raises interest rates.

Purpose of Variable Interest Rates in Finance

Variable interest rates are commonly used in various financial products, including:

• Mortgages – Rates adjust periodically based on changes in the market.
• Lines of Credit – Interest rates on personal and home equity lines of credit (HELOCs) vary over time.
• Credit Cards – Some credit cards have variable annual percentage rates (APRs) tied to the prime rate.
• Investment Loans – Borrowers financing investments may choose variable rates to benefit from potential savings.
• Savings Accounts – Some high-interest savings accounts offer variable rates based on the Bank of Canada’s rate.

How Variable Interest Rates Work

Linked to a Benchmark Rate

Variable rates adjust based on external reference points, including:

• Bank of Canada overnight rate – The rate at which banks lend money to each other overnight.
• Prime lending rate – The interest rate banks charge their most creditworthy customers.
• LIBOR or CDOR – Global and Canadian benchmark rates affecting financial products.

Rate Adjustment Frequency

Lenders update variable interest rates at regular intervals, such as:

• Monthly or quarterly for some loans and mortgages.
• Annually for certain long-term financial products.

Effect on Loan Payments

• If interest rates rise, borrowing costs increase, leading to higher monthly payments.
• If interest rates fall, borrowers pay less interest, reducing overall costs.

Example: A borrower with a variable-rate mortgage at prime + 1% may see their payments increase if the prime rate rises by 0.5%.

Fixed vs. Variable Interest Rates

Feature	Fixed Interest Rate	Variable Interest Rate
Stability	Remains constant for the loan term	Fluctuates based on market conditions
Risk Level	Lower risk	Higher risk due to rate changes
Potential Savings	May be higher if rates drop	Can be lower when rates remain stable

Example: A borrower choosing a fixed-rate mortgage locks in a stable rate, while a variable-rate mortgage fluctuates based on the prime rate.

Advantages and Disadvantages of Variable Interest Rates

Advantages

• Lower initial rates – Variable rates are often lower than fixed rates at the start.
• Potential cost savings – Borrowers benefit if interest rates decrease.
• Flexible loan terms – Some loans allow switching to a fixed rate if needed.

Disadvantages

• Uncertain payments – Monthly payments may increase unexpectedly.
• Higher risk exposure – Rising interest rates lead to higher borrowing costs.
• Market dependency – Borrowers must monitor interest rate trends.

Related Terms

• Prime rate – The interest rate banks use to set lending rates.
• Fixed interest rate – An interest rate that remains the same over the loan term.
• Amortization period – The total time required to repay a loan.

Interesting Fact

In Canada, borrowers with variable-rate mortgages often have the option to convert to a fixed-rate mortgage, allowing them to lock in rates when interest rises.

Statistic

According to the Bank of Canada, over 40 percent of Canadian mortgages in 2022 had variable interest rates, reflecting borrower confidence in lower initial costs.

Frequently Asked Questions (FAQ)

1. How often do variable interest rates change?

Variable rates typically adjust whenever the prime rate changes, which can occur multiple times per year.

2. Can I switch from a variable to a fixed rate?

Yes, most lenders allow borrowers to convert their variable-rate loan to a fixed rate under specific conditions.

3. Are variable interest rates always cheaper than fixed rates?

Variable rates start lower but may increase over time, making them riskier than fixed rates.

4. What happens if interest rates rise significantly?

Borrowers with variable-rate loans face higher monthly payments, potentially leading to financial strain.

5. When should I choose a variable interest rate?

Variable rates are best for borrowers who can handle risk and expect interest rates to remain stable or decrease.