What is a Floating Interest Rate?
A floating interest rate refers to a variable interest rate that changes over the duration of the debt obligation. It is the opposite alternative to a fixed interest rate loan, where the interest rate remains constant throughout the life of the debt. For instance, residential mortgages can be acquired at both fixed interest rates as well as at floating interest rates that periodically adjust per interest rate market conditions.
The change in interest rate with a floating rate loan is typically based on a reference rate that is outside of any control by the parties involved in the contract. The reference rate is usually a recognized benchmark interest rate, such as the prime rate, which is the lowest rate that commercial banks charge their most creditworthy customers (typically, large corporations or high net worth individuals).
Floating interest rate debt often costs less than fixed rate debt, depending on the yield curve. In compensation for lower fixed rate costs, borrowers must bear higher interest rate risk. Interest rate risk refers to the risk of rates rising in the future. When the yield curve is inverted, then the cost of debt with floating interest rates may actually be higher than fixed rate debt, but an inverted yield curve is the exception rather than the norm. Floating rates are more likely to be less expensive borrowing in the case of a long-term loan, such as a 30-year mortgage, because lenders require higher fixed rates for longer term loans, due to the inability to accurately forecast economic conditions over such a long period of time.
Sometimes, the floating interest rate is offered with other special features, such as limits on the maximum interest rate that can be charged, or limits on the maximum amount by which the interest rate can be increased from one adjustment period to the next. These features are mostly found in mortgage loans. Such qualifying clauses in the loan contract are primarily to protect the borrower from the interest rate suddenly increasing to a prohibitive level that would likely cause the borrower to default.
Uses of Floating Interest Rate
There are many uses for a variable interest rate. Some of the most common examples are:
- Floating interest rates are used most commonly in mortgage loans. A reference rate or index is followed, with the floating rate calculated as, for example, “the prime rate plus 1%”.
- Credit card companies may also offer floating interest rates. Again, the floating interest rate charged by the bank is usually the prime rate plus a certain spread.
- Floating rate loans are common in the banking industry for large corporate customers. The total rate paid by the customer is decided by adding (or, in rare cases, subtracting) a spread or margin to a specified base rate.
Changes in the floating interest rate are based on a reference rate. Two of the most common reference rates used with floating interest loans are the prime rate in the U.S., and in Europe, the London Inter-bank Offered Rate (LIBOR). The floating rate is equal to the base rate plus a spread or margin.
For example, interest on a debt may be priced at the six-month LIBOR + 2%. This simply means that, at the end of every six months, the rate for the following period will be decided on the basis of the LIBOR at that point plus the 2% spread. Floating interest rates may be adjusted quarterly, semi-annually, or annually.
Pros and Cons
The following are benefits of a floating interest rate:
- Generally, floating interest rates are lower compared to the fixed ones, hence, helping in reducing the overall cost of borrowing for the debtor.
- There is always a chance of unexpected gains. With higher risk also comes the prospect of future gains if the interest rate falls. The lender may also enjoy unexpected profit if interest rates rise to an unexpectedly high rate over the term of the loan.
The following are potential disadvantages of a floating interest rate loan:
- The interest rate depends largely on market situations which can prove to be dynamic and unpredictable. Hence, the interest rate risk may increase to a point that the loan may become difficult to repay.
- The unpredictability of interest rate changes makes budgeting more difficult for the borrower. It also makes it harder for the lender to accurately forecast future cash flows.
- In times of unfavorable market conditions, financial institutions try to play it safe by putting the burden on customers. They charge high premiums over the primary rate, ultimately affecting the pockets of borrowers.
Floating interest rate wrap-up
Interest rates are some of the most influential components in the economy. They help in shaping day-to-day decisions of individuals and corporations, such as determining whether it’s a good time to buy a house, take out a loan, or put money in savings. The level of interest rates is inversely proportional to the level of borrowing, which in turn affects economic expansion. Interest rates influence stock prices, bond markets, and derivatives trading.
Thank you for reading the CFI guide to understanding how a variable interest rate works. To continue your development as a world-class financial analyst, these additional resources will be helpful: