The Risks of Taking Out a Variable-Rate Loan

What is a variable-rate loan?

A variable-rate loan carries an interest rate that can change over time. Unlike fixed-rate loans where the rate (and your payments) stay the same throughout the loan term, financial products with variable rates fluctuate with market conditions and the economy.

Keep in mind that most personal loans come with fixed rates. Variable rates are typically found in specific financial products:

• Personal lines of credit (PLOCs)
• Some student loans
• Credit cards
• Adjustable-rate mortgages (ARMs)
• Home equity lines of credit (HELOCs)

Personal lines of credit are popular with consumers looking for a flexible borrowing option, often with lower interest rates than they’d get with a credit card. These products have shorter draw periods, usually three to five years. Then, you’ll have to pay off any remaining balance during the repayment portion of your loan term, says Colleen Briggs, vice president of consumer lending at Michigan-based Dart Bank.

Lines of credit can be unsecured or secured loans. To get an unsecured line of credit, lenders qualify you based on your income and creditworthiness. However, some banks offer personal lines you can secure with funds in a bank account. Meanwhile, a HELOC is secured by your home as a second mortgage. 

How do variable interest rates work?

Variable interest rates aren’t set arbitrarily. They’re typically tied to an underlying financial index or benchmark rate, plus a margin the lender sets based on your creditworthiness and other borrowing standards.

Factors influencing variable interest rates

Several moving parts can cause variable interest rate fluctuations:

• Benchmark indices: Most variable rates are tied to financial benchmarks like the prime rate, LIBOR (which is being phased out), the secured overnight financing rate (SOFR), or Treasury yields.
• Federal Reserve monetary policies: When the Fed adjusts its benchmark rate, it directly impacts these indices. Between March 2022 and July 2023, the Fed hiked its benchmark rate by more than 5 percentage points, with some easing in 2024. 
• Economic conditions: Broader economic metrics like inflation, unemployment rates, GDP, and job growth can influence rate trends.
• Your credit profile: Some lenders may adjust your margin based on your credit score or financial situation. Generally, the higher your credit score, the lower the interest rate you qualify for.

How often can variable rates change?

Rate fluctuations depend on the type of variable-rate product you have. For personal lines of credit, rate changes typically occur within 30 days of a change in the underlying index; most lenders adjust their rates monthly or quarterly. On the other hand, HELOCs, ARMs, and credit card rates closely follow Fed rate increases and can change daily. 

Potential risks of variable-rate loans

Before you take out a loan with a variable interest rate, make sure you’re prepared for the possible risks.

Payment uncertainty due to rate fluctuations

With a variable-rate loan, you run the risk of your payments creeping up over time if rates rise, which can become unaffordable. That’s why experts recommend paying the line of credit off as soon as possible and being disciplined with how you use it.

“I usually only recommend a personal line of credit to people who feel confident that they can pay the balance off quickly after assuming the debt,” says Ryan Hughes, founder and portfolio manager with Bull Oak Capital in San Diego, California. 

Long-term costs may be higher

In addition to interest rate fluctuations, you’ll pay several fees with PLOCs. Some lenders charge origination and application fees on their PLOCs, plus monthly or annual account maintenance fees and late fees.

Harder to budget and plan for

With changing rates (and payments), a variable-rate loan can throw your ability to budget into disarray. Knowing your cap is critical so you can budget for rising payments if rates dramatically increase. 

If you find payments becoming harder to make, you may want to look into a fixed-rate personal loan to pay off your line of credit.

“Sometimes, where people get in danger is robbing Peter to pay Paul,” Briggs says. “I would use [a personal line of credit] as a safety net — not an everyday thing.”

Comparing variable-rate loans to fixed-rate loans

When you’re shopping for a loan, first determine whether a fixed or variable interest rate fits your financial situation. 

Stability vs. flexibility

While fixed-rate loans offer stable, predictable payments, you won’t have the flexibility that comes with a line of credit, where you pay interest only on the amount you draw as opposed to the entire credit line you’re approved for. Plus, PLOCs typically have lower starting rates than other forms of borrowing.

Situations where variable rates might be advantageous

A variable-rate PLOC can be useful if you have smaller expenses spread out over time, such as for:

• Home renovations
• Unexpected emergencies
• Medical bills 
• Mitigating cash flow from an irregular income
• Higher interest debt consolidation

“A personal line of credit can be an excellent option for unexpected expenses beyond what you may have set aside in an emergency fund,” Hughes says. “Because you don't need to pay any interest if you don't draw from the line of credit, it makes for a great emergency backup, barring any annual fees.”

Strategies to mitigate risks associated with variable-rate loans

1. Set up a financial buffer

Briggs advises beefing up your emergency savings as much as possible to lower your reliance on a variable-rate line of credit. By socking away money consistently over time, you won’t have to turn to risky loans where your payments might fluctuate with rates.

“Pay yourself. Have something set aside,” she advises. “If emergencies happen and you've tapped all of that, then it's good to have this personal line. But still pay yourself — maybe not as much. If you were originally putting $100 every paycheck into a savings account, and then you ran out of savings and you had to tap the personal line, maybe put $25 or $50 in every paycheck, but pay down your line as fast as you can.”

Because PLOCs are based on variable interest rates, you could be paying that down for “a long, long time until you can pay down the principal,” Briggs notes.

2. Consider refinance options

While you can’t refinance out of a personal line of credit, your lender may offer you the option of paying it off with a fixed-rate loan, which you’ll then repay in equal installments with a stable rate over a longer time period. This could give you the breathing room you need.

3. Monitor economic indicators

While no one has a crystal ball to predict the future, there are certain economic warning signs that rates might be headed up. These include an uptick in inflation, volatility in the job market, geopolitical issues, and, of course, Federal Reserve monetary policy.