Variable versus Fixed-Rate Credit Cards
Written by Curtis Arnold
Posted On: March 4, 2009
All cards can be classified as either fixed or variable rate. Fixed rate means the interest rate never changes—at least, in theory. The rate on variable-rate cards, however, can go up or down, depending on the prime rate. Variable rate cards have become much more prevalent in recent years. In 2006, 86% of all credit cards were variable rate, while five years earlier, fixed-rate cards were more widespread than variable rate cards.
The rates of most variable cards mirror the prime rate. If the prime rate increases .25%, the rate on the card also increases .25%, typically by the next billing cycle.
Almost all variable-rate cards in the United States are tied to the prime rate, but it’s only one index issuers use to decide on rates. A few cards are tied to the London Interbank Offered Rate (LIBOR), the rate banks pay when they borrow money from each other in England. (The LIBOR is usually lower than the prime rate.) A few cards are tied to other indices, such as Treasury Bills. The index should be disclosed in the Schumer Box.
Although lenders start with the prime rate, very few cards have rates at or below prime. Lenders determine the actual rate of a variable rate card by adding the spread, a certain number of percentage points or “basis points,” to the prime rate. For example, under “Variable Rate Information,” a Schumer Box might say “Prime + 6,” meaning that the rate is determined by adding the prime rate plus a spread of 6%. Add the current prime rate of 3.25% to the spread, and you’ll find out that the effective interest rate is 9.25% (3.25% + 6%). It’s simple math.
Exceptions to the Rule
One notable exception is called a floor, which is a minimum rate that goes into effect if the prime rate drops below a certain level. For example, let’s assume the rate on your card is “Prime + 4%,” with a floor of 10%. If prime drops to 5%, your card would still have a 10% APR. No 9% (5% + 4%) for you because of the card’s 10% floor.
Until recently, only a few cards had rate floors, particularly cards targeted to consumers with bad or no credit. Now, more cards are using rate floors to avoid having to pass on all of the Fed interest rate cuts that we’ve recently witnessed. According to Linda Sherry, Director of National Priorities for Consumer Action, a national non-profit education and advocacy organization, rate floors can also be associated with default and cash advance APRs. Sherry points out that the “never lower than” rates for penalty and cash advance APRs are always very high.
Some card issuers reserve the right to change the terms and conditions, including the APR, for virtually any reason…at any time. The controversial universal default clause is one way card issuers justify such changes.
I sincerely hope these tips help you understand some of the nuances of variable rate cards. Understanding such nuances could translate into huge savings in your finance or interest charges. Please share your thoughts on this topic in our active credit forum.
As a reminder, you can compare low rate variable and low fixed rate credit cards on CardRatings.com!
Curtis Arnold, a nationally recognized consumer educator and advocate, has been educating consumers about credit cards since 1998. New! Curtis is the author of "How You Can Profit from Credit Cards: Using Credit to Improve Your Financial Life and Bottom Line" (FT Press, 2008). He is also the co-author of the upcoming Complete Idiot's Guide to Person-to-Person Lending (Alpha Books/Pengiun Group USA, April 2009), a contribitor to The Ultimate Allowance (InnerWealth Publishing, 2008) and is extensively featured in 42 RulesTM for Driving Success With Books (Super Star Press, January 2009).