A variable rate loan is a lending arrangement under which the interest rate varies in accordance with changes in a standard rate. For example, the interest rate on a variable rate loan may be set to change in accordance with variations in the rate paid on certain U.S. Treasury securities. These loan arrangements may contain caps, where the size of a rate change cannot exceed a certain amount. There may also be a limitation on the frequency of adjustments to the interest rate, or a delay in the number of months before the initial rate change occurs.
The initial interest rate charged on this type of loan is typically lower than the rate charged on a fixed rate loan, which allows less creditworthy individuals to qualify for a loan. However, they are then at risk of incurring excessive loan payments later in the loan term if market interest rates increase. The combination of lower-income borrowers and the risk of higher loan payments means that there tends to be a higher loan default rate on variable rate loans.