What Is a Floating Interest Rate?
A floating interest rate is an interest rate that moves up and down with the market or 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.
- Floating rates are carried by credit card companies and are commonly seen with mortgages.
- Floating rates follow the market or track an index.
- Floating rates are also called variable rates.
Understanding Floating Interest Rates
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.
Most credit cards have floating interest rates.
For example, if someone takes out a fixed-rate mortgage with a 4% interest rate, the individual will pay that rate for the lifetime of the loan, and the payments will be the same throughout the loan 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, changing the monthly payments.
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 an individual 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).
Advantages and Disadvantages of Floating Rates
ARMs tend to have lower introductory interest rates than fixed-rate mortgages, and that can make them more appealing to some borrowers. Those 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 may choose an ARM.
The other advantage is that floating interest rates may float down, thus lowering the borrower's monthly payments. The key disadvantage is that the rate may float upward and increase the borrower's monthly payments.
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. 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.
James Di Virgilio, CIMA®, CFP®
Chacon Diaz & Di Virgilio, Gainesville, FL
When it comes to long-term borrowing, it is best to stay away from a floating rate or any type of variable loan, and this is particularly true when interest rates are very low, as they are currently.
It is important to know exactly what your debt will cost you so that you can budget accurately without any surprises.
When you choose to use a variable rate loan, you are essentially gambling that interest rates will be lower in the future. Each year, a changing interest rate environment could bring a new and potentially higher interest rate, which could significantly increase the amount of interest you will have to pay.
When rates are historically low, as they are today, the odds are good that rates will increase in the future, and not decrease, making a floating rate loan a poor choice. Therefore, using a fixed-rate loan, especially in our current interest rate environment, is the wisest move.