What Is a Variable Interest Rate, and What Does It Mean for Your Credit Card Debt

Unlike a fixed interest rate, which remains constant, a variable interest rate can change over time. Most credit cards have variable interest rates tied to the U.S. prime rate or a similar benchmark. Here's a complete definition of a variable interest rate, how it affects your credit card debt, and how you could avoid credit card interest altogether.

What is a variable interest rate?

Simply put, a variable interest rate is an interest rate that can change over time. Variable interest rates are generally tied to an underlying index, such as the U.S. prime rate. A variable APR is a similar concept, although an APR can be slightly higher than an interest rate, as it includes interest and fees directly related to borrowing money.

If the variable interest rate's underlying index increases, the rate will increase. Conversely, if the index decreases, the rate will go down.

Since there are typically no fees directly involved with borrowing money on a credit card, the terms "interest rate" and "APR" can be used interchangeably in the case of credit card interest.

How credit card interest rates vary

The overwhelming majority of credit cards use variable interest rates. As an example, one of the credit cards in my wallet right now has an interest rate that varies based on the U.S. prime rate plus 14.49%. As I write this, the U.S. prime rate is 4.25%, so my current interest rate for this credit card is 18.74%.

Since it's used so often as a credit card interest rate benchmark, it's a good idea to understand some of the basic principles of the U.S. prime rate. In a nutshell, the prime rate is a common, short-term interest rate that is used as a basis to price various loan products. The U.S. prime rate is directly dependent on the federal funds rate, which is the interest rate set by the Federal Reserve, and that can be adjusted over time.

The current 4.25% U.S. prime rate is based on the federal funds target rate of 1.00%-1.25%. The rule of thumb is that the U.S. prime rate is 3 percentage points higher than the upper end of the target rate, so if the Fed were to raise the federal funds target rate to 1.25%-1.50% at its next meeting, it would translate to a U.S. prime rate of 4.50%, and would result in the interest rates of credit cards tied to the prime rate rising by 0.25% as well.

How your credit card interest is calculated

Credit card issuers typically calculate your interest each month using the average daily balance method.

First, your credit card issuer determines your daily periodic rate (DPR), or the interest rate you pay each day, by taking your current variable interest rate and dividing by 365, generally rounded to the nearest 10,000th of a percentage point (four decimal places). Using my credit card, with a current APR of 18.74% as an example, this translates to a DPR of 0.0513%.

Next, your credit card issuer determines your average daily balance, which is calculated by adding up your balances on each day of the billing cycle and dividing by the total number of days. As a simplified example, if your billing cycle was 30 days long and you had a zero balance for 15 days and a $1,000 balance for the next 15 days, your average daily balance during the billing cycle is $500.

Finally, your daily periodic rate is multiplied by the number of days in the billing cycle, and then is multiplied by your average daily balance, in order to calculate your monthly interest, or finance charge.

An example of how rate hikes could affect your credit card interest

To illustrate how variable interest rates can affect consumers, consider that the average credit card debt for households that carry balances is just over $16,000 according to a 2016 report by ValuePenguin.

So, let's say that you're an average balance-carrying household, and that your overall interest rate is currently 15.99%. In a 30-day billing cycle, this means that you'll pay about $210 in interest.

However, if the Federal Reserve decides to raise rates by a quarter-point, because your credit card interest rates are most likely variable and tied to the U.S. prime rate, your interest rate will rise to 16.24%. This translates to interest charges of about $214 on a carried debt of $16,000. This doesn't sound like much, but consider that it translates to nearly $50 per year that could have been applied toward your balance instead.

Furthermore, if the federal funds rate rises to, say, 3%, over the next few years as many experts have predicted, it would mean a 1.75% increase from the current interest rate, which would be passed on to you as a consumer. In our example, this would mean that a household with a $16,000 credit card balance would now pay $233 per month in interest -- or roughly $175 per year more than they're paying now.

The good news: You may be able to avoid paying interest on your credit card debt

Fortunately for you as a consumer, competition in the credit card industry has never been higher, which has resulted in some of the best credit card offers we've ever seen.

Many of these offers are in the form of 0% intro APR promotions, and while the exact terms offered change from time to time, it's possible to find a 0% intro APR for up to 21 billing cycles as of this writing. If you're interested, check out our up-to-date list of the best 0% intro APR offers currently on the market.

Also, don't be discouraged if you don't have excellent credit. Many 0% intro APR offers are available to consumers who have "good" credit, which is generally considered to mean a FICO score in the high 600's or better.

Finally, if you have a substantial amount of existing credit card debt and you'd rather see your payments applied to your principal, rather than to interest charges, many 0% intro APR offers apply to transferred balances as well. In fact, there are some excellent introductory offers specifically designed for balance transfers, including 0% intro APRs as well as balance transfer fee waivers in some cases.

The bottom line is that when lenders compete, as they are doing rather intensely right now, it creates opportunities for savvy consumers. If you're tired of massive interest charges on your credit card debt or want to avoid paying interest in the future, now could be a smart time to take advantage.

5 Simple Tips to Skyrocket Your Credit Score Over 800!Increasing your credit score above 800 will put you in rare company. So rare that only 1 in 9 Americans can claim they're members of this elite club. But contrary to popular belief, racking up a high credit score is a lot easier than you may have imagined following 5 simple, disciplined strategies. You'll find a full rundown of each inside our FREE credit score guide. It's time to put your financial future first and secure a lifetime of savings by increasing your credit score. Simply click here to claim a copy 5 Simple Tips to Skyrocket Your Credit Score over 800.

The Motley Fool has a disclosure policy.