Floating Interest Rate

A floating interest rate, also known as a variable interest rate, is a rate that fluctuates over time based on changes in a benchmark or reference rate. Floating rates are commonly tied to financial market conditions, adjusting periodically according to changes in indexes such as the federal funds rate in the US or the Secured Overnight Financing Rate (SOFR). 

Floating rates are used in various financial products like adjustable-rate mortgages, business loans, and bonds. Lenders and financial institutions may offer them to borrowers looking to capitalize on falling rates. 

How Do Floating Interest Rates Work? 

A floating interest rate adjusts at regular intervals, typically in response to changes in a benchmark or reference rate, such as the prime rate, the lowest rate financial institutions charge to their highest credit quality customers.

It can also typically adjust in response to changes in the LIBOR, the London Interbank Offered Rate, now being replaced by SOFR. The Secured Overnight Financing Rate is an influential interest rate used to price U.S dollar-denominated derivatives and loans.

When settling a financial agreement such as a floating rate loan, lenders specify an adjustment period during which the interest rate can increase or decrease. A borrower’s payment obligations can rise or fall depending on the direction of the reference rate. 

 Floating rates can be appealing in a low-interest-rate environment but carry risks if rates increase. 

Fixed Interest Rates Vs. Floating Interest Rates 

A floating interest rate is typically considered riskier than fixed rates. A fixed interest rate remains constant throughout the life of the loan, while a floating rate adjust periodically based on market benchmarks.

Fixed rates provide predictability and stability in payments, which can be beneficial for budgeting, especially long-term. On the other hand, floating rates offer potential savings when interest rates decline but pose higher risks if rates rise. 

Borrowers may choose between fixed and floating rates based on their risk tolerance and expectations for future interest rates, as well as other features like the maximum interest rate on certain instruments, macroeconomic factors and market conditions.

What are Floating-Rate Notes (FRNs)? 

A floating-rate note (FRN) is a type of bond with a variable interest rate. The interest rate is usually tied to a short-term benchmark rate, and it is an appealing instrument to investors because they can benefit from higher interest rates if rates rise.

Since FRNs have variable rates, their coupon payments tend to be unpredictable. A coupon payment is the interest payment for a bond.

Sometimes floating-rate notes can have a cap and a floor, which allows the investor to know which will be the minimum and maximum rates paid for that note.

An FRN's interest rate can change as often or as frequently as the issuer chooses, from once a day to once a year.

Advantages of Floating Interest Rates 

Floating interest rates can have several advantages:

• A floating interest rate can result in lower borrowing costs when interest rates are declining or remain low over time, as interest payments might be reduced if markets drop.
• A floating interest rate also offers the potential for lower initial payments compared to fixed-rate loans for financial instruments such as mortgage loans 
• They also offer flexibility in refinancing or restructuring loans based on changing financial conditions. 

Disadvantages of Floating Interest Rates 

On the other hand, while a floating interest rate can be advantageous in some scenarios, they carry risks, especially in a rising-rate environment. 

• Payments can increase unexpectedly if market interest rates rise, making loans more expensive over time.
• Floating rates are also harder to budget for as payment amounts can vary with each adjustment period and are hard to predict.
• More generally, a floating interest rate involves a lack of certainty and stability, as its fluctuations can be unpredictable.

Therefore, floating rates are not suitable for risk-averse borrowers or those with tight cash flow constraints, whom might consider instruments with a fixed interest rate instead such as fixed rate mortgage.

Floating Interest Rate Example 

To understand floating rates, we can look at an example of floating rate loans and mortgage interest rates.

Let’s say you take out an adjustable-rate mortgage (ARM), also known as floating rate mortgage. These are home loans that adjust their rates according to a preset margin and a major mortgage index such as SOFR.

Your mortgage has been given a margin of 2.5% and the SOFR starts at 2%. Your initial interest rate would be 4.5% (2% + 2.5%). However, if the SOFR increases to 3% the following year, your interest rate would adjust to 5.5%.

Contrarily, if the SOFR were to decrease to 1%, your rate would adjust to 3.5%.

If you were to get a fixed rate loan however, the fixed interest rate would not change for the duration of the mortgage loan and therefore your monthly payment would not vary.

FAQs 

What Financial Products Use Floating Interest Rates? 

There are a few financial instruments which are typically associated with a floating interest rate. 

A good example is adjustable-rate mortgages (ARMs). A mortgage borrower with a floating rate tied to the prime rate, may see their monthly payments fluctuate depending on whether the rate rises or falls over time. 

If the prime rate increases by 1%, the borrower’s interest rate and subsequent payments will increase accordingly. Conversely, if the benchmark rate falls, the borrower will benefit from reduced monthly payments. 

Another example of financial instruments with floating interest rates are credit cards, corporate loans and Floating-Rate Notes (FRN).

Do Credit Cards Have Floating Rates? 

Many credit card companies establish floating rates for their credit cards. The rates usually fluctuate according to the prime rate, and the cardholders receive an agreement stating that the card’s annual percentage rate is based on that particular rate plus a certain margin. This margin can vary depending on the individual’s credit quality and the card product level. 

As an example, if the established prime rate is 6% and the added margin amount on the credit card is 10%, then the credit card rate will be 16%. 

Should I Choose a Floating Rate or a Fixed Rate? 

The appropriate option for you as a borrower will depend on your financial situation and your goals. A floating interest rate might help you save money, but this could change at any moment and increase risk. It could also make budgeting difficult. Fixed interest rates, on the other hand, do not change over time and provide a bigger sense of security. Therefore, choosing one or the other will depend on your financial situation and risk tolerance.

How Often is a Floating Rate adjusted? 

Floating interest rates are also commonly referred to as variable or adjustable rates because they can fluctuate over the period of a debt obligation. The rate can be updated periodically, on a monthly, quarterly or annual basis.

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