The meaning of floating interest rates refers to a variable interest rate that changes over the duration of the debt obligation. It is the opposite of a fixed interest rate, where the interest rate remains constant throughout the life of debt. Loans, such as residential mortgages, can be acquired at both fixed interest rates as well as at the interest on floating rate that periodically adjust per interest rate market conditions.
Breaking Down Floating Interest Rate
The change in interest rate with a floating rate loan is typically based on a reference, or “benchmark”, 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 for loans.
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 a higher interest rate risk. Interest rate risk, for bonds, 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. However, an inverted yield curve is the exception rather than the norm.
Floating rate is 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. There is a general assumption that interest rates will rise or increase over time,
Sometimes, a 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.
Floating Interest Rate Calculation
It must be noted that several factors tend to influence the calculation of floating interest rates. Some of the economic factors are given below:
- Repo Rate
- Government’s Monetary Policies
- Inflation Rate
- Fiscal Deficit
- Global And Foreign Interest
Since the rate of this type of interest is susceptible to changes, the calculation can often be dubious. This is why it is better to calculate floating interest rates with the help of an investment or a loan EMI calculator.
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When Is Floating Rate Relevant?
Individuals can understand the relevance of floating rate under these situations –
While applying for a loan:
Typically, intending borrowers pick loan floating rate when they expect a reduction in the interest rate or a dynamic rate through their loan tenure. Additionally, such an interest type enables individuals to make prepayments easily and pay off debt faster and at a much lower interest burden.
While investing:
Individuals can choose investment instruments with floating rate when they anticipate the base rate will be the same, or an expected change will be in their favour. Under such situations, the interest earned on investments made either stays the same or is likely to increase. Nonetheless, individuals must make it a point to weigh the benefits of the variable interest rate to decide whether it will help them to save or earn more over time.
Advantages Of Floating Interest Rate
The following are the benefits of a variable 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. The borrower will enjoy a benefit if interest rates decline, because the floating rate on his loan will go down.
- The lender will enjoy additional profit if interest rates rise, because he can then raise the floating rate charged to the borrower.
Disadvantages Of Floating Interest Rate
The following are the potential disadvantages of a variable interest rate loan:
- The interest rate depends largely on market situations which can prove to be dynamic and unpredictable. Hence, the interest rate 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 will charge high premiums over the benchmark rate, ultimately affecting the pockets of borrowers.
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.
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