A variable interest rate is a type of interest rate whose effective rate is tied to a collection of representative rates called an interest rate index. Variable interest rates help keep lending instruments profitable during changes in the general level of interest rates.
Risk
Variable interest rates help minimize the risk lenders incur when making a loan at a specific interest rate. For example, if the market interest rate is 3 percent, a bank makes a loan at 5 percent interest expecting to make 2 percent in profit from interest. If market rates increase to 4 percent, the lender only makes 1 percent in profit and will lose money if interest rates rise above 5 percent.
Benchmarks
Banks minimize exposure to interest rate risk by tying lending products to a certain benchmark interest rate. This ensures that the loan remains profitable within the margins the bank requires. Benchmark rates include the prime rate, which is used often in short-term business lending.
Lending
An adjustable-rate mortgage changes the interest rate a homeowner pays at regular intervals to keep up with changes in market rates to keep the mortgage profitable for the lender. Credit cards are often priced similarly with banks charging interest based on the prime rate.
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