The Variable Rate Conundrum

When rates are low, the perception is that it's a great time to consider a variable rate loan product for your purchase. The reality is that this is arguably one of the worst times to take a variable rate loan. Variable rates offer the advantage of a temporary lower payment for a short period of time to help get someone into their purchase (be it a home, auto, or aircraft). However, evaluating such a program requires careful consideration of the additional risks of a variable rate.

1. If a client is considering a variable rate, the client assumes the additional rate risk normally reserved for the bank. The risk stems from rate market instability. As we all know, the economy is subject to large swings and what may be a low PRIME rate today (also referred to as New York Prime) could increase 2 or 3-fold in a relatively short period. As an example, the last time our economy was in somewhat similar shape, rates increased from 8% to 20% in a period of 27 months. Although no one can guess where rates will go in the upcoming months and years, customers need to balance their short term gains over the risk of longer term rate increases.

2. Variable rates offer a low payment today, but there's no magic here - with a variable rate product the rate risk also shifts the risk of cash flow to the borrower. Although fixed rates may be slightly higher in the short term, comparatively they are still well below the historical average of 9.25%. Given what we've seen with rate volatility, a customer should ask, "Would I finance a 30-year mortgage on a variable rate, even if it was 2% below what a full-term fixed rate today would be?" Many would argue that these are the programs that contributed to our current Real Estate crisis. In some cases, the variable rate will make sense (i.e. short-term borrowing) ... but in many cases, and in light of recent news, customers may want to place a higher value on the peace of mind that comes with a low fixed-interest rate product.

3. The best time to secure a variable rate product is in a decreasing rate market. As rates have for the most part bottomed-out, you may be safer with a fixed-rate alternative today, locking-in the currently low longer-term rates. Variable rates are likely only going up from here, and history shows us that many companies who locked-in variable rate loan structures in the late 1970s were out of business by the early 1980s when their rates were in the 20%'s - the last time a parallel can be drawn on the state of the economy.

Finally, the one caveat we would mention is that if you are accustomed to short-term borrowing this type of structure may make sense for you. For example, in measuring the economics of only owning the asset for a year, you may come out ahead with a short-term variable rate product.