Floating Rate Loan
A loan in which the interest rate varies with each payment period.
Floating Rate Loan Details
Variations in the interest rate of a floating rate loan are based on a reference or benchmark rate beyond the parties' influence in the contract. Instead, it is usually a prime rate, or the lowest rate, set by commercial banks for their most trusted clients, such as high net worth individuals and big corporations.
Depending on the yield curve, the cost of a floating rate loan is generally lower than that of a fixed-rate loan. A yield curve is a line that shows the interest rates of bonds having the same credit quality but maturing at different dates. An inverted yield curve, while more of an exception rather than the norm, indicates that floating rate loans may turn out to be more expensive than fixed-rate debts.
In some cases, a floating interest rate loan possesses other unique properties. For example, a lender may put a cap on the interest rate that a loan can incur or the amount that permits an interest rate increase from one adjustment period to the next. Such loan attributes essentially serve to protect borrowers from extreme rate fluctuations that may cause them to default.
Example of Floating Rate Loan
One classic example of a floating rate loan is an adjustable-rate mortgage (ARMs). Let’s say Mrs. Severson bought a house with a floating rate loan that started at 2% for her first payment period. If she had taken out a fixed-rate mortgage, she would be paying interest at the same rate for the entire duration of her loan. But since hers is a floating rate mortgage, her next interest rate payments will be more or less than the 2% she started with.
Typically, changes in the interest rate of an adjustable-rate mortgage (ARM) are based on a preset margin. This is then added to a key mortgage index like the London Inter-Bank Offered Rate (LIBOR), which is the benchmark used by global banks when lending among themselves.
Therefore, if Mrs. Severson took out her ARM at 2% based on LIBOR at that time, but this rate has increased to 3% in the current adjustment period, she will pay a total interest rate of 5% (the initial interest rate of 2% plus the 3% adjustment) for that current adjustment period.
Significance of a Floating Rate Loan
When the Great Recession was over, people naturally gravitated towards fixed-rate loans. No more than 6% of loans nowadays are floating, although they composed 20% of loans taken out over the last ten years before the economic downturn. But while floating rate loans may be discouraging because of their changing interest, they serve their purpose in certain situations.
For example, people who pay off a floating mortgage and sell the property before the next period of adjustment will be able to save money. Borrowers who expect their equity to increase faster than the rise in home values will also find an ARM a good option. Lastly, floating mortgages usually have lower initial interest rates than fixed-rate loans. When interest rates drop, so do the debtor’s monthly payments.