Variable Rate Loans

By: Tim Brugger, Debt.com Financial Fitness Trainer

While they may or may not be the bane of existence many make them out to be, variable rate loans have certainly seen their share of negativity. Many blame these loans, at least in part, for the recent housing market debacle and the backlash we’ve felt since. Avoiding the pitfalls associated with variable rate loans doesn’t take a Stephen Hawking-like mind, its simply a matter of collecting information, and then using that information to make an informed decision.

Debt-to-Income Ratio

A key factor in the decision to lend is a little calculation banks call debt-to-income (DTI) ratio. They add up living expenses such as rent or mortgage payments, other loan payments and the like (including the new loan payment) and subtract that from monthly income to arrive at the debt-to-income ratio. A DTI in the 35% – 40% range is considered pretty good for a home loan. Car loans may or may not require DTI numbers.

Lowering payments for a new loan, either by extending the terms or lowering the initial interest rate, will provide some people access to funds they would not have otherwise qualified for because of DTI concerns.

Now, imagine a borrower who has a debt-to-income ratio of 43%, and is denied a home loan as a result. The mortgage banker, being the nice guy that he is, shares a great idea that just occurred to him, “we can use a variable rate loan and drop the monthly payment enough to get your DTI to 40%, problem solved.”

This is where things can get a bit ugly. If saving 1 or 1.5 percent now is the difference between qualifying and not qualifying for a loan, then there is a good chance that when rates rise, the higher payments will become burdensome, if not impossible to withstand.

Rate Adjustments

Some variable auto loans will adjust their rates as often as monthly. This means with every rate increase, there will be a subsequent increase in payments. What appeared to be a manageable monthly outlay a short while ago, can quickly become an overwhelming monthly burden.

The Worst Case

Don’t sign anything until you know how high your variable loan rate can go over the course of the term. Most lenders put a cap on the rates, often in the 5% – 6% range. When you start to do the math, you begin to realize how much that can impact monthly payment obligations. For example, if your initial rate for a variable rate auto loan is 6 percent with a payment of $250 per month, then imagine how high that payment goes if the annual rate reaches 11 percent.

Conclusion

Time now for the moral of this potentially woeful tale; look before you leap. There’s a reason age-old adages are “age-old,” it’s because they ring true. Before jumping into your new car or home, make certain you understand the particulars of the loan offered. If we’ve learned anything these past 2-3 years, it’s that things can and do change. Understanding the impact of that potential change, and preparing for it, can save a lot of heartache later.