Terms of a loan, regardless of the type, are dependent on an interest rate. The interest rate determines how much the loan will cost the borrower. There are fixed interest rates, which remain the same throughout the life of the loan, and variable interest rates, which can fluctuate.
While fixed interest rates offer the borrower security in terms of knowing payments will never change, variable rates offer a risk-reward opportunity. The advantage of a variable interest rate is that if it goes down, so too will the borrower's payments — alas, the reverse is also true. Payments on the loan will go up when the rate increases.
Variable interest rates change based on a predetermined index, such as the publicly published prime rate or a U.S. Treasury bill rate.
The prime rate is the foundation that banks use to set interest rates on various short-term loans, including credit cards, according to Bankrate.com. The prime rate moves up or down based on interest rates set by the Federal Reserve.
When considering a variable interest loan, it is important for the borrower to examine the rate at which it fluctuates. The Federal Reserve advises borrowers — especially those wanting a mortgage or home equity loan — to find out how often the value of the index changes and how high it has risen in the past to better gauge how often payments could change over the loan's life.
When it comes to credit cards, it is important for users to be aware of changes to the national interest rate by the Federal Reserve, since it is so closely tied into the rate at which carrying a balance on the card is determined.
Chad Brooks is a Chicago-based freelance business and technology writer who has worked in public relations and spent 10 years as a newspaper reporter. You can reach him at firstname.lastname@example.org or follow him on Twitter @cbrooks76.