Definition & Meaning:

On some bank loans, the amount of money you are charged in interest changes from month to month. If this happens, you are paying a 'variable interest rate' on the money you have borrowed. But why does the bank change the interest rate on 'variable rate' loans?

The main reason is that value of money is constantly decreasing through what is called 'inflation', sometimes it is decreasing more and at other times less. In addition, you may be surprised to hear that banks also have to borrow money themselves from their customers and other banks to be able lend money. And the interest rate that they have to pay changes over time.

For a bank, a 'variable interest rate' is the least risky type of interest rate that they can charge on a loan. Any change in the inflation rate or in the cost to them of borrowing money they can pass on to customer (by either increasing or decreasing their interest rate they pay on their loan). Guaranteeing that earnings from the loan doesn't decrease.

Most banks will change the amount of interest you pay for your loan every month, but some banks may only change the interest rate every 6 months or every year (often with mortgages).

For a borrower, having a 'variable interest rate' on a loan could be a gamble. Although the amount of money you pay in interest could go down, it could also go up.

There are also two other different methods of paying interest on a loan, 'fixed rate' (where the interest rate is fixed) and 'split rate' (where the interest rate is both fixed and variable).

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Also Called:

Flexible Rate, Adjustable Rate, Variable Rate.

Related Vocabulary:

Annual Percentage Rate, Redemption Penalties, The Principal, Fixed Interest Rate, Split Interest Rate, Preferential Interest Rate.

To learn more vocabulary connected to loans, you can do a free online exercise on bank loan vocabulary.