Variable vs. Fixed Rate Interest

Overview
Fixed interest is just that—fixed! It stays the same throughout the duration of the loan. A variable interest rate is one that changes and is linked to another changing rate. This means it can increase or decrease over time, but is limited to the original terms of the agreement.

Usually the agreement will read something like "Prime + 1.5%". This means that the variable rate will be the Prime interest rate (the most popular Prime rate index being published in the Wall Street Journal daily), plus an additional 1.5%. So, if Prime is 6%, the variable rate is 7.5%.

Practical Uses
You'll most likely see this on the back of a credit card offer (in what is referred to as the "Schumer Box") where the APR will be described as "Prime + 7% (Currently 14.7%)"

Another instance will be for a variable rate mortgage loan. Such offers might be described as "Prime - 1%" for the extremely credit-worthy borrower.

Quick Tip
Here's a quick little tip on how to know if it's better to go for fixed or variable interest. Go to your bank's website and look at the difference between a 3-month CD and a 12, 24, or even 36-month CD. If at any time you see the longer-term CD lower than the 3-month, it might be a good idea to go for the variable rate interest. This is because the bank is expecting interest rates to drop in future. This can't be your only deciding factor because, like all things finance, it's a matter of timing.

Deeper Dive
The Prime rate follows the Federal Funds Rate (aka the "Fed" Rate) by around +3%. So, when the Federal Funds Rate has a 'target' of 0.25%, the Prime rate becomes 3.25%. That is one key method for the Federal Government is able to influence the economy, because my simply adjusting the Fed Rate target, they are able to change all Variable Rate Interest loans in the country that are tied to the Prime Rate. (There are many more steps in between, but this a simplified explanation.)

One More Thing...
Sometimes you will see LIBOR, which stands for the London InterBank Offered Rate. (Sometimes Three-Month LIBOR or Six-Month LIBOR.) It is a composite rate, calculated and averaged over time and then tied to financial contracts. You may or may not see it, but in case you do you'll at least have some idea of where it comes from and will be able to go and learn more about how it's used.