Definition of Floating Interest Rate
Floating interest rates alter frequently. The interest rate “floats,” reflecting economic or financial market circumstances. It often syncs with an index, benchmark, or market circumstance.
A floating interest rate is either adjustable or variable, as it can change throughout a financial obligation.
Floating Interest Rates: Understanding
A variable interest rate rises or decreases with the market or a benchmark. The benchmark interest rate for loans and securities is often the London Interbank Offered Rate (LIBOR), federal funds rate, or prime rate (the amount financial institutions charge their most creditworthy corporate customers).
Banks and financial institutions impose a spread above the benchmark rate for consumer loans and debt based on criteria including asset type and credit quality. Thus, a floating rate may be “LIBOR plus 300 basis points” or “plus 3%.”
Interest rates on all loans and debt instruments are variable. Credit cards and mortgages are particularly prone to these issues.
Floating rates can change quarterly, semiannually, or annually.
Floating-Rate Product Types
Home loans with variable rates are called adjustable-rate mortgages (ARMs). ARM rates adjust depending on a margin, a primary mortgage index, or the Monthly Treasury Average (MTA). If an ARM has a 2% margin above LIBOR and LIBOR is 3% when the mortgage adjusts, the mortgage rate resets to 5% (the margin plus the index).
Most credit cards carry variable or floating interest rates on delinquent amounts. In the credit card agreement, new cardholders will learn that the APR is based on a rate or index plus a margin. The agreement states, typically, “This APR will vary with the market.”
The primary basis for credit card interest rates is the prime rate banks set whi, which the Federal Reserve may change several times a year, Credit card companies add a margin to that rate that varies by card product and accountholder credit quality.
Floating vs. Fixed Interest Rate
A variable interest rate differs from a fixed rate. Fixed interest rates don’t fluctuate. It may apply to the entire loan or debt obligation or only a portion.
Fixed or variable interest rates are available for residential mortgages. With fixed interest rates, the mortgage rate remains constant throughout the arrangement. With floating or variable rates, mortgage rates fluctuate with the market.
A fixed-rate mortgage with a 4% interest rate will have duplicate payments throughout the loan.
A variable-rate mortgage may start with a 4% rate and move between up and down, affecting monthly payments during the loan term.
Floating-interest loan example
Herbert and Amanda buy a home. A $500,000, 30-year 7/1 ARM is taken out. This indicates their loan’s interest rate is 2% for seven years. After that, the mortgage resets to a yearly variable interest rate. The variable rate matches LIBOR.
Their interest rate reached 4% in the eighth year, matching LIBOR. In the ninth year, LIBOR dropped marginally, lowering their interest rate to 3.7%. In the 10th year, LIBOR drops again, and the couple’s variable interest rate drops to 3.5%. The couple’s interest will fluctuate annually until the mortgage is paid off or refinanced.
Pros and Cons of Floating Rates
Advantages
- Some borrowers prefer floating-rate mortgages because they offer lower starting interest rates.
- Consider an ARM if you plan to sell your house and repay the loan before the rate rises or anticipate rapid equity growth as home prices rise.
- Floating interest rates may decrease monthly payments.
Disadvantages
- The biggest drawback of a variable rate is that it might rise and make monthly payments unfeasible.
- Floating-rate loans are unpredictable, making determining cash flow and long-term borrowing costs challenging.
- Variables beyond your control determine rates unless you’re the Fed chair.
Adviser Perspective
Chacon Diaz & Di Virgilio, Gainesville, FL
Avoid floating-rate or variable-rate loans for long-term borrowing, especially when interest rates are low. You must know your debt costs to budget correctly and avoid surprises.
Variable-rate loans are a bet on reduced interest rates. A shifting interest rate environment might deliver a new, higher interest rate each year, significantly increasing interest payments.
A variable-rate loan is the wrong choice when rates are historically low since they are likely to rise. In a low-interest-rate climate, a fixed-rate loan is the best option.
Floating or fixed interest rates: which is better?
That depends on your finances, view of interest rates, and the economy as a borrower. Because it varies, a floating interest rate may save you money but make financial planning and budgeting difficult. If it rises, you may have to spend more. Thus, floating rates are risky. Fixed interest rates never fluctuate. You may prepare confidently and feel more secure in a rising-rate environment.
An example of a floating rate
Floating rates are a base rate (typically the U.S. prime rate or LIBOR) plus a margin. The variable rate of a debt instrument pegged to LIBOR plus a 6% margin is 12% when LIBOR is 6%.
Do credit cards have floating rates?
Floating rates are on most credit cards. Rates vary with the prime rate. Credit card companies add a percentage to set the card’s interest rate. If the prime rate is 8% and the extra amount is 12%, the credit card rate is 20%.
Bottom Line
A variable interest rate, or floating interest rate, fluctuates with its benchmark rate. Floating interest rates rise with the benchmark rate and vice versa.
Lower monthly payments save borrowers money if a variable rate is reduced. But if it rises, they’ll have to pay more each month. Borrowers’ main drawback to floating interest rates is increased borrowing costs.
Conclusion
- Unlike fixed interest rates, floating interest rates vary frequently.
- Credit card and mortgage businesses employ floating rates.
- The market, index, or benchmark interest rate determines floating rates.
- Floating rates are fluctuating rates.
- They’re riskier than fixed rates.
