What is a 'Floating Interest Rate'
A floating interest rate is an interest rate that moves up and down with the rest of the market or along with an index. It can also be referred to as a variable interest rate because it can vary over the duration of the debt obligation. This contrasts with a fixed interest rate, in which the interest rate of a debt obligation stays constant for the duration of the loan's term.
BREAKING DOWN 'Floating Interest Rate'For example, residential mortgages can be obtained with fixed interest rates, which are static and cannot change for the duration of the mortgage agreement, or with a floating or adjustable interest rate, which changes periodically with the market. For example, if someone takes out a fixed rate mortgage with a 4% interest rate, he pays that rate for the lifetime of the loan, and his payments are the same throughout the loan's term. In contrast, if a borrower takes out a mortgage with a variable rate, it may start with a 4% rate and then adjust, either up or down, thus changing the monthly payments.
How Floating Interest Rates Adjust
In most cases, adjustable-rate mortgages (ARMs) have rates that adjust based on a preset margin and a major mortgage index such as Libor, the cost of funds index (COFI) or the monthly treasure average (MTA). For example, if someone takes out an ARM with a 2% margin based on Libor, and Libor is at 3% when the mortgage's rate adjusts, the rate resets at 5% (the margin plus the index).
Credit Cards With Floating Interest Rates
Mortgages are not the only type of loans that can have floating interest rates. Most credit cards also have floating interest rates. As with mortgages, these rates are tied to an index, and in most cases, the index is the current prime rate, the rate that directly reflects the interest rate set by the Federal Reserve several times per year. Most credit card agreements state that the interest rate charged to the borrower is the prime rate plus a certain spread.
Advantages and Disadvantages of Floating Rates
With mortgages, adjustable-rate mortgages tend to have lower introductory interest rates than fixed rate mortgages, and that can make them more appealing to some borrowers, especially to borrowers who plan to sell the property and repay the loan before the rate adjusts or borrowers who expect their equity to increase quickly as home values increase. The other advantage is that floating interest rates may float down, thus lowering the borrower's monthly payments. The key disadvantage, however, is that the rate may float upward and increase the borrower's monthly payments.