Floating interest rate is the 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 with fixed interest rate, where interest rate of debt obligation would stay constant for loan duration.
Generally, residential mortgages are obtained with fixed interest rates the nature of which is static interest rates for duration of mortgage period. The other used rates are floating or adjustable interest rate, the nature of which is to change along with change in market interest rates. For example; Sinra Inc takes loan from agriculture development bank at 10% fixed rate when the market conditions are similar.
If the company takes loan at adjustable rate, things would be different. If market condition allows similar market rates at 8% and the loan is floating interest rate, the interest rate would be adjusted to 7% to reflect 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 preset margin and a primary mortgage index as primary lending rate of central bank, libor, monthly treasure average rate, etc. If primary lending rate is taken as base and 2% extra is charged, the floating rate would be primary lending rate plus 2%.
Uses of Floating Interest Rate
- Floating interest rates are generally used in mortgage loans with twist of reference or index rate. For instance, the loan would come as primary lending rate plus 1%.
- The financial institutions providing credit card service also offer adjustable interest rates by using the reference or index rate.
- Adjustable rate loans are common practice in the banking industry for large corporate borrowers. The rate in totality to paid by the borrower is decided by adjusting spread of margin to specified base rate. The base rates are generally reference or index rate.
Pros and cons of Floating Rates
- Floating interest rates have lower introductory interest rates than fixed rate loans. This makes them more attractive to various class of borrowers. The borrowers who plan to sell their collateral assets to repay the loan before adjustment or borrowers who wants to increase their equity before increase in floating interest rates might want to choose floating interest loans.
- If interest rates with respect to reference rate or index rate, it would lower down the borrower’s interest payments and bring down the cost.
- The primary disadvantage of floating interest rates is what 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 specific feature would depend upon the requirement of borrower. When floating interest based loans are chosen, the borrower perceives that base rate will either stay same or decline over time. Then the monthly interest payments would either be same or there will be 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 borrower sees 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. If the borrower is looking for saving on interest rate costs in short term, floating rate loans are generally set at 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 loan 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 existing loan.
Hence, choosing floating and fixed interest rate based loans becomes the 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.