Variable Interest Rate

A variable interest rate is an interest rate that is not set in stone; it can change over the term of a loan or an investment. These changes typically occur in response to shifts in a benchmark interest rate, such as the cash rate set by the Reserve Bank of Australia (RBA). This is particularly relevant in car finance Australia.

The defining feature of a variable interest rate is its fluctuation. This means that for borrowers, your interest payments can go up or down, and for investors, your earnings can similarly fluctuate.

In stark contrast, a fixed interest rate remains constant for a set period, or the entire term of the loan or investment, providing certainty in payments or earnings.

How a Variable Interest Rate Works

• For Loans:

  • When you take out a loan with a variable interest rate, the rate is not locked in. Instead, it will move up or down over the loan’s term. These movements are primarily influenced by changes in an underlying benchmark rate, most notably the cash rate set by the Reserve Bank of Australia (RBA). Lenders then add their own margin to this benchmark rate.
  • What this means for you, the borrower, is that your monthly loan repayments can either increase (if the variable rate goes up) or decrease (if the variable rate goes down). This directly impacts your budgeting, as your outgoings are not fixed.
  • Benchmark rate: The RBA cash rate is a key benchmark in Australia. It’s the target interest rate for the overnight money market. When the RBA changes this rate, it influences the cost of borrowing for banks, which then typically pass these changes on to their customers. Lenders then add their own margin (a percentage on top) to cover their operating costs, risk, and profit. So, your variable rate = (RBA Cash Rate + Lender’s Margin), though it’s not always a direct, immediate pass-through.
  • Example scenario: If the RBA increases the cash rate by 0.25%, a lender’s variable home loan rate, or a variable car loan rate, is highly likely to increase by a similar amount. This would lead to higher monthly repayments for the borrower. Conversely, a cut in the RBA cash rate would typically result in lower repayments.

• For Investments:

  • When you have an investment product with a variable interest rate, the rate of return you earn on that investment will adjust periodically. These adjustments are usually tied to prevailing market rates or the institution’s internal benchmarks.
  • This means that your earnings from the investment can fluctuate. During periods when interest rates are generally rising, your variable-rate investment will likely offer higher returns. However, if interest rates fall, your earnings will also decrease.
  • Example scenario: A variable-rate savings account might offer higher returns when general market interest rates are increasing. This is attractive to savers who want to benefit from a rising rate environment, but they must also accept the risk that returns could fall if rates decline.

Advantages of a Variable Interest Rate

While variable interest rates introduce an element of uncertainty, they also offer distinct advantages for both borrowers and investors:

• Potential for Lower Rates (for Borrowers): This is a key draw. If market interest rates, particularly the RBA cash rate, fall during your loan term, your variable interest rate will likely decrease. This directly translates to lower monthly repayments, reducing the overall cost of your loan and freeing up cash flow. This can be particularly beneficial for car loans or home loans in a declining rate environment.
• Flexibility (for Borrowers): Variable-rate loans often come with greater flexibility compared to their fixed-rate counterparts. Borrowers typically face fewer restrictions or penalties for making extra repayments or for paying off the loan in full before the scheduled end of the term. This allows for greater control over your debt and the ability to save on total interest if your financial situation improves.
• Potential for Higher Returns (for Investors): For those with variable-rate investments, such as savings accounts, a rising interest rate environment can lead to increased earnings. As market rates go up, the interest rate on your investment adjusts upwards, allowing your savings to grow faster.
• Transparency: Changes to variable interest rates are often tied to publicly known benchmarks, like the RBA cash rate announcements in Australia. This provides a level of transparency, allowing individuals to anticipate potential changes to their repayments or earnings.

Disadvantages of a Variable Interest Rate

Despite the potential benefits, variable interest rates carry notable risks and disadvantages that borrowers and investors must consider:

• Unpredictability and Budgeting Uncertainty (for Borrowers): The primary drawback is the inherent unpredictability of future payments. Since the interest rate can change at any time, your monthly loan repayments (whether for a mortgage or a car loan) can fluctuate. This makes budgeting more challenging, as you can’t be certain of your exact outgoings for the entire loan term.
• Exposure to Rising Rates (for Borrowers): If market interest rates, or the underlying benchmark rate, increase, your variable interest rate will also rise. This directly leads to higher monthly repayments, which could potentially stretch a borrower’s budget, especially if they are already operating close to their financial limits.
• Lower Potential Returns (for Investors): The reverse is true for investors. If market interest rates fall, the interest earned on variable-rate investments will also decrease. This means investors will earn less interest on their savings or investments, potentially hindering their financial growth.
• Interest Rate Risk: This term encapsulates the fundamental risk associated with variable rates: the risk that interest rates will move in an unfavourable direction for you. For borrowers, this means rates go up; for investors, it means rates go down. Managing this risk requires ongoing monitoring of market conditions.

Examples of Financial Products with Variable Interest Rates

Variable interest rates are prevalent across a wide range of financial products in Australia:

• Loans:

  • Most standard home loans (mortgages) in Australia: The vast majority of Australian home loans are variable, directly impacted by RBA cash rate decisions.
  • Lines of credit: These flexible borrowing facilities typically have variable interest rates.
  • Credit cards: The interest rate on credit card debt is almost always variable, and often quite high, making it susceptible to market movements.
  • Some personal loans: While some personal loans offer fixed rates, many are variable, especially those offered by challenger banks or online lenders.
  • Many car loans: While fixed-rate car loans are common, variable-rate options are also available, particularly from banks and credit unions.

• Investments:

  • Standard savings accounts: The interest rate earned on these accounts fluctuates with market conditions, allowing banks to adjust rates as the RBA cash rate changes.
  • Money market accounts: Similar to savings accounts, these offer variable interest rates that track short-term market rates.
  • Some types of bonds (e.g., floating-rate notes): Unlike fixed-rate bonds, floating-rate notes have interest payments that adjust periodically based on a benchmark rate, allowing investors to benefit from rising rates but also exposing them to falling rates.

Factors Influencing Variable Interest Rates

Several key factors determine how and when a variable interest rate on a loan or investment will change:

• Central Bank Cash Rate (e.g., RBA in Australia): This is by far the most significant influence. In Australia, the Reserve Bank of Australia (RBA) sets the official cash rate, which is the target interest rate for the overnight money market. When the RBA announces a change to this rate, commercial lenders typically adjust their variable home loan and car loan rates in response, either passing on the full change or a portion of it.
• Economic Conditions: Broader economic indicators play a crucial role. Factors like inflation, economic growth (Gross Domestic Product – GDP), and employment data are closely monitored by the RBA, as they directly influence its decisions on the cash rate. A strong economy with rising inflation might lead the RBA to increase rates, which in turn impacts variable rates.
• Market Competition: The competitive landscape among lenders can also influence variable rates. If there’s fierce competition for new borrowers or deposits, lenders might absorb some increases in their own funding costs or even offer slightly lower rates to attract or retain customers.
• Lender’s Funding Costs: Banks and other lenders need to borrow money themselves to lend it out. The cost at which they can obtain these funds from wholesale markets or through customer deposits (like savings accounts) directly impacts the margin they add to the benchmark rate. If their funding costs rise, they may increase their variable rates to maintain profitability.
• Borrower’s Risk Profile: While the core variable rate moves with the market, the specific margin added by the lender might still vary based on the borrower’s creditworthiness. For some variable-rate products, a borrower with an excellent credit score might receive a slightly lower rate than one with a less favourable history, even though both rates are variable.

7. Key Takeaways About Variable Interest Rates

Understanding variable interest rates is crucial for effective financial planning in Australia:

• Offer Flexibility and Potential Savings: For borrowers, the main appeal of a variable rate is the potential for lower repayments if interest rates decline. They also often come with fewer penalties for making extra repayments or paying off the loan early.
• Carry the Risk of Increased Costs: The flip side is the inherent risk that if interest rates rise, your loan repayments will increase, potentially stretching your budget. For investors, falling rates mean lower earnings.
• Require Closer Monitoring: Unlike fixed rates, variable rates demand more active monitoring of market conditions and RBA announcements, so you can anticipate and plan for changes to your financial commitments or returns.
• Suitable for Those Who Can Manage Payment Fluctuations: Variable rates are best suited for individuals or businesses who have sufficient financial buffer to comfortably absorb potential increases in their loan repayments and are comfortable with the associated interest rate risk.

Related Terms

To deepen your understanding of variable interest rates and their impact on finance, consider exploring these related concepts:

• Fixed Interest Rate: An interest rate that remains constant for a set period, providing predictability but potentially missing out on falling rates.
• Benchmark Rate: A standard interest rate (like the RBA cash rate) that other interest rates in the market are based on.
• Interest Rate: The cost of borrowing money or the return on an investment, typically expressed as an annual percentage.
• Loan Term: The total duration over which a loan is scheduled to be repaid.
• Inflation: The rate at which the general level of prices for goods and services is rising, which the RBA aims to control through its cash rate decisions.
• Refinancing: The process of replacing an existing loan with a new one, often done to secure a better interest rate (fixed or variable) or change the loan terms.
• Reserve Bank of Australia (RBA) / Central Bank: Australia’s central bank responsible for monetary policy, including setting the cash rate, which heavily influences variable interest rates.

Conclusion

When it comes to variable interest rates, it’s all about weighing the potential for reward against the inherent risk. While they offer the alluring possibility of lower repayments if interest rates fall, they also carry the significant risk of increased costs if rates rise. Variable rates demand a closer eye on market conditions and the Reserve Bank’s announcements. Ultimately, the choice between a variable and fixed interest rate hinges on your individual financial stability, your comfort with fluctuating payments, and your outlook on future interest rate movements. Consider your capacity to absorb potential repayment increases before committing.

Hit the Road in Australia: Let Alpha Finance Help

Navigating the choice between a fixed and variable interest rate for your car loan is a big decision, and it’s one we can help with at Alpha Finance. We understand the Australian market and offer a range of car finance solutions designed to suit different financial situations and risk tolerances. Whether you’re looking for the predictability of a fixed rate or the potential savings of a variable one, our team can help you understand the implications for your budget. Talk to Alpha Finance today to explore your options and find the right car loan that gets you on the road. Visit us at Alpha Finance.