The risk-taking borrower will choose a loan with a variable interest rate. In the end, he speculates with a falling interest rate, lower monthly installments and hopes for early repayment of the total debt. But a variable interest rate can also bring disadvantages, which must not be ignored under any circumstances.
Ultimately, political decisions or events can lead to a rise in the prime rate on which the variable interest rate is based, causing the monthly loan installments to skyrocket.
Variable or fixed interest?
If the consumer decides to take out a loan, he will be paid an agreed loan amount which he must repay – including interest. The interest rate agreed in advance is valid for the entire repayment term. Long-term loans, such as real estate financing, are often offered with a fixed interest rate, which is shorter than the actual repayment term. If the fixed interest rate has expired, it comes to renewed negotiations.
If the prime rate has changed, so follows an interest rate adjustment – either the borrower receives a lower or significantly higher lending rate. Another option that is used by many borrowers is the variable rate.
Why does the interest rate rise or fall?
Both sides, borrower and bank, agree on the automatic adjustment of the interest rate. The variable interest rates are based on the interest rates of the European Central Bank, the current market interest rates, higher interest rates or Interbank. When an interest rate adjustment takes place is specified in the loan agreement.
The borrowers and the banks agree on a fixed time window, so that – as a rule – a quarterly change can occur. However, there are also half-year adjustments. If an interest rate adjustment follows, the bank may not set the amount of the interest rate independently. The institution is based on the market interest rate, which is determined by the key interest rate of the European Central Bank. It should be noted that interest rates and lending rates never have the same level.
The Bank may and must also charge management fees or risk premiums, which are responsible for an increased lending rate. In the end, however, the key interest rate plays a decisive role – if this rises by 1.5 percent, the lending rate also rises by 1.5 percent. If the prime rate drops by 2.0 percent, the lending rate also falls by 2.0 percent. However, interest rates are not always linked to the prime rate – sometimes the Interbank plays an important role.
The Interbank describes the interest rate used by commercial banks when they lend money to each other. While the Interbank may look similar to the prime rate, it does provide a better insight into the cost of banks. It should be noted that the Interbank can change daily so that fluctuations are possible at any time. However, the policy rate is adjusted only every three months.
Who should choose a variable interest rate?
It can not be said at all whether the borrower should opt for a variable or fixed interest rate. So there are several advantages and disadvantages that must be considered in advance. Since an adjustment can be made in both directions, there is thus the likelihood that the borrower will benefit, but sometimes the monthly rate may also skyrocket.
If the prime rate falls, the loan is much cheaper. In this case, the borrower benefits, provided that he has opted for a variable interest rate. However, if the interest rate rises, the borrower must expect additional costs. Here, the borrower benefits, who has chosen a fixed interest rate. So if you are unsure whether the key interest rate rises, you should opt for a long-term fixed interest rate.
However, if the borrower wants to make special payments or sometimes repayments before the end of the normal maturity, it is probably better if he chooses a variable interest rate. In this case, he does not have to pay a prepayment penalty. This “penalty payment” can only be made if the borrower has chosen a fixed interest rate. In the end, of course, far-sightedness is needed and a bit of luck is necessary if one decides on variable interest rates.
Of course, a variable interest rate is risky – for the borrowers and of course for the banks. As market rates can fluctuate widely, there is always the possibility that lending rates may change as well. Anyone who chooses a variable interest rate must also be aware that monthly loan installments can skyrocket.
Such additional costs must be included in the planning in advance, so that any interest rate adjustments do not lead to financial problems.