Variable interest rate loans use a reference rate, such as LIBOR or the Prime Rate, to calculate interest and payments. These rates are updated at set intervals, and variable rate loan agreements typically include interest rate caps. Alternatively, fixed rate loans have a set interest rate for the life of the loan.
A loan or other financial transaction that includes a variable or variable interest rate typically specifies a reference rate, known as a benchmark. Reference rates are used to calculate the interest rate and payment due on a loan. Common reference rates include the London Interbank Offered Rate (LIBOR) and the US Prime Rate.
Variable interest rates are generally updated at set intervals, such as monthly or annually. The LIBOR reference rate is commonly used on adjustable rate mortgage (ARM) loans. ARMs have a fixed rate for a certain number of years. After the fixed interval, the interest rate is usually updated each year, based on the reference rate in the contract.
For example, a 5/1 ARM will have a fixed interest rate for the first five years. The ‘1’ indicates that the rate will be adjusted at the end of year 5 and every year after that. The typical contract establishes that the adjustable rate will be equal to LIBOR, plus 3%. In year six, and every year thereafter, the interest rate will be adjusted up or down, based on current LIBOR. The borrower will pay this new interest rate for one year, until the rate adjusts again.
While LIBOR is a popular choice for an ARM reference rate, other rates can be used as well. Any published rate, such as the Consumer Price Index or the unemployment rate, can be used as a reference rate. The Prime Rate is commonly used in the United States as the benchmark rate for credit card interest rates.
Both the lender and the borrower must choose reference rates that they cannot influence or control. This will help avoid a conflict of interest. Parties using reference rate contracts are also protected from interest rate risk. The borrower pays the going rate on a loan, while the lender continues to make a profit on the margin listed in the loan agreement.
To help ensure a fair rate for the borrower, variable rate loan agreements typically include a lifetime and annual interest rate cap. These limits place limits on the interest rate regardless of the change in the reference rate. However, there are challenges with using a reference rate. The borrower will not know what the interest rate on the loan and payments will be from year to year. Also, even with interest rate caps, if interest rates rise, loan payments may increase to a level that the borrower cannot afford.
Alternatively, both lenders and borrowers can opt for fixed rate loan contracts instead of variable contracts that use reference rates. Fixed rate loans include an interest rate for the life of the loan. In general, the interest rate will remain the same unless the lender makes late payments or defaults on the loan.
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