A floating interest rate is the same as an adjustable or variable or interest rate loan (ARM). The rate of interest charged, and payments can float and fluctuate with the market.
Floating interest rate means that the interest rate will change periodically throughout the term of the loan. The interest rate can go up or down depending on the economic conditions. It is also known as variable interest rate as it varies over the term of the loan.
A floating interest rate can be adjusted either quarterly, half yearly or annually. There is no fixed time for the revaluation, however, borrowers are promptly informed about the same.
There are various indexes upon which the floating interest rate of different types of loans will be based such as prime rate, London Interbank Offered Rate (LIBOR) and federal funds rate. LIBOR is typically the most common benchmark that is used in adjustable rate mortgages.
In this case, the lender will reevaluate the interest rate as per LIBOR after a specific time period and add a margin to it. The borrower will be told about these terms beforehand and if he chooses to agree he will have to pay the interest whether it is high or low at the time of adjusting.
Floating rate of interest means that the interest rate will change periodically and based on the updated rate of interest, the borrower has to pay the amount. This amount can be high or low, there is no guarantee.
Contrary to this, a fixed rate of interest remains unchanged throughout the period of the loan. The interest rate at which the loan was disbursed at the beginning will stay the same despite the market conditions. If the rate of interest is lowered at any point in time in the economy, the borrower will still have to pay the fixed rate of interest at which he agreed on.
With a fixed interest rate, the monthly or yearly payments are predefined for the borrower. On the other hand, with a floating interest rate, the payment amount is not fixed and the borrower can end up paying more.
The advantages of choosing a floating interest rate are:
Now, let's talk about the disadvantages of floating rate of interest:
As the rate of interest fluctuates during the course of the loan, the borrower cannot accurately calculate the payments. However, they can calculate the payments up to the point when the rate of interest is supposed to be adjusted. Let us understand this with an example.
Suppose a man has taken a mortgage of $2,00,000 for a period of 5 years. In his contract, the lender has determined the rate of interest at 5% annually. However, this rate of interest will be adjusted at the end of every year based on the market conditions. For the first year, the borrower must pay an interest of $10,000 (2,00,000 x 5/100) annually.
Now, at the end of the year, the lender adjusted the interest rate as per the market conditions and the new interest rate is now 8% annually. Then, the borrower must pay $16,000 (2,00,000 x 6/100) annually which means he has to pay an additional $6000 that year.
The next year the interest rate is revised and it is now 4.5%. So, the borrower will pay $9000 dollars as interest on his loan for the third year.
This is how a floating interest rate varies. This is a simple calculation, however, the calculation can get complex based on the terms of the loan. For example, if the lender agrees to a floating interest rate at a reducing balance, then the borrower has to pay the interest for a given period at the principal amount outstanding.
Floating interest rates are unpredictable meaning there is no guarantee that the borrower will benefit from it. Based on the economy, market and other indexes, this rate will change. It can either result in a profit for the borrower or the lender. It is important for individuals to study their options thoroughly in regards to their income and cash flow. If they can afford to pay a higher interest in the future then floating interest rates can be beneficial for them if and when the rates fall.