Floating Interest Rate – What It Is And When You Should Choose It

Meaning

A floating interest rate is a flexible interest rate that fluctuates as per the direction of the market or index. It is also popularly called a variable interest rate as it varies over the duration of the debt obligation.

This differs from the fixed interest rates, where the interest rate of debt obligation would stay constant for the loan duration.

Generally, residential mortgages are obtained with fixed interest rates the nature of which is static interest rates for the duration of the mortgage period.

The other used rates are floating or adjustable interest rates, the nature of which is to change along with change in market interest rates.

For example; Sinra Inc takes loans from an agriculture development bank at a 10% fixed rate when the market conditions are similar.

If the company takes loans at an adjustable rate, things would be different. If the market condition allows similar market rates at 8% and the loan is a floating interest rate, the interest rate would be adjusted to 7% to reflect the current market condition.

The interest rates would go up and down as per the market conditions.

In many cases, floating rate mortgages have rates to be adjusted on a preset margin and a primary mortgage index as the primary lending rate of the central bank, LIBOR, monthly treasure average rate, etc.

If the primary lending rate is taken as the base and 2% extra is charged, the floating rate would be the primary lending rate plus 2%.

Uses of Floating Interest Rate

  1. Floating interest rates are generally used in mortgage loans with a twist of reference or index rate. For instance, the loan would come as a primary lending rate plus 1%.
  2. The financial institutions providing credit card services also offer adjustable interest rates by using the reference or index rate.
  3. Adjustable rate loans are common practice in the banking industry for large corporate borrowers. The rate in totality to be paid by the borrower is decided by adjusting the spread of the margin to the specified base rate. The base rates are generally reference or index rates.
See also  What is a Warrant in Finance? (Explained)

Pros and cons of Floating Rates

  1. Floating interest rates have lower introductory interest rates than fixed-rate loans. This makes them more attractive to various classes of borrowers. The borrowers who plan to sell their collateral assets to repay the loan before adjustment or borrowers who want to increase their equity before the increase in floating interest rates might want to choose floating-interest loans.
  2. If interest rates with respect to reference rate or index rate, it would lower the borrower’s interest payments and bring down the cost.
  3. The primary disadvantage of floating interest rates is that if the rates float upward. This would increase the borrower’s monthly payments.

When to Choose a Floating Interest Rate?

Changing any type of loan with a specific feature would depend upon the requirement of the borrower.

When floating interest-based loans are chosen, the borrower perceives that the base rate will either stay the same or decline over time.

Then the monthly interest payments would either be the same or there will be a reduction in the loan payments.

Similarly, under floating interest loans, the borrowers can pay prepayments if they have excess income.

This will help to pay off the loan faster and reduce the total interest levied on the loan. Hence, if the borrower sees a rise in income in the future, the floating interest certainly looks better in that prospect.

Floating interest rate loans are highly beneficial for those who are not sure about the movements in interest rates and would want to go along with the market interest rates.

See also  How Do Equity Research Firms Make Money? And Who are They?

If the borrower is looking for saving on interest rate costs in short term, floating rate loans are generally set at a lower rate than fixed-rate loans.

This surely suits the borrowers in terms of cost savings as well.

Change from Fixed to Floating or Vice-Versa

It is very possible to alter the loan terms and conditions. Hence, the shift can be made from fixed interest rate loans to floating interest rate-based loans and vice versa.

But on the negative side, the borrower may be charged processing and documentation fees generally extending up to 1 % of the loan amount.

That means the borrower should be able to absorb the cost while changing the terms of an existing loan.

Hence, choosing floating and fixed interest rate-based loans becomes an important question early when taking loans.

This would impact the monthly interest payments. Hence, the borrower should exercise due diligence to make informed decisions that would the suit financial position and needs of the borrower itself.