Understanding the dangers of a variable rate loan is important if you are considering applying for a new mortgage, refinancing your current mortgage, or applying for a personal loan or credit card. Selecting the right option for your situation could save you money and ensure you only get the mortgage you can truly afford.

What is a Variable Rate Loan?

A variable interest rate loan is a loan where the amount of interest charged on the balance frequently changes based on the current conditions of financial markets. This is usually calculated using an underlying benchmark or index such as the official bank rate set by the Bank of England. The Bank of England uses the official bank rate to influence other interest rates in an effort to keep inflation low and stable. 

If you have a variable rate loan, your interest rates on the outstanding balance will go down when the referencing index (often called the official bank rate) goes down – this can be a huge benefit and save money. However, this potential change goes both ways. When the index or official bank rate goes up, so too do the interest rates on your variable rate loan. Banks are not able to change interest rates at their own discretion. Interest rates are typically set by the Monetary Policy Committee. The committee meets every 6 months to decide the base rate.

What is a Danger of Taking a Variable Rate Loan?

  • Risk of Higher Payments: because the interest rate on a variable rate loan is tied to an index like the official bank rate, there is a risk of higher payments if the official rates go up. Be sure to have a conversation with your lender and ask which category index (usually LIBOR or SOFR) the company uses when calculating interest rates. Don’t be afraid to ask questions during the evaluation process!
  • Risk of Defaulting on the Loan: A lender can increase your rate whenever the markets allow, leading to a potentially costly jump in your repayments. As a result, this means you may have a greater risk of defaulting on a variable rate loan because the interest rates are so unpredictable. If the markets happen to shift and your interest rates skyrocket, you run the risk of not being able to make the payments and defaulting on your loan. The lender can seize your home or property in the event of a default to try to recover their losses. This is an example of having an asset as collateral for the loan.
  • Potential Prepayment Penalties: it’s important to check the fine print of your variable rate loan contract for mention of prepayment penalties. If interest rates end up going up, most people think they can refinance or sell the asset and pay the lender back to avoid paying the burden of higher rates; however, prepayment penalties mean that you may need to pay a high fee for paying the loan back early. There are instances where prepayment penalties only last a portion of the life of the loan or extend through the full term.

Are There Alternatives to a Variable Rate Loan?

Yes! A fixed interest rate loan is an alternative to variable rate loans. A fixed rate loan is one where the interest rate charged remains the same for the entire term of the loan, regardless of whether the market interest rates go up or down. If interest rates are especially low, such as they are now in 2021, it is generally a good idea to opt for a fixed rate loan. Alternatively, variable rate loans may make sense when rates are currently high but in a falling pattern.

Build Credit to Help Get Better Interest Rates on Loans

Having a better credit score and credit history makes you look more stable to the lender which will result in more favourable interest rates on credit cards and other loan products. Building your credit score is something to think about if you are worried about the danger of taking a variable rate loan.

Portify helps our members build healthy credit through monthly membership payments in partnership with all major Credit Reference Agencies in the UK. Download the app and get started in 3 minutes or less, today!

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Lauren Robson is the digital communications manager at Portify.
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