Floating Interest Rate: Definition, How It Works, and Examples

What Is a Floating Interest Rate?

A floating interest rate is one that changes periodically: the rate of interest moves up and down, or "floats," reflecting economic or financial market conditions. Often, it moves in tandem with a particular index or benchmark, or with general market conditions. It can also be referred to as an adjustable or variable interest rate because it can vary over the duration of the debt obligation.

Key Takeaways

  • A floating interest rate is one that changes periodically, as opposed to a fixed (or unchanging) interest rate.
  • Floating rates are carried by credit card companies and commonly seen with mortgages.
  • Floating rates follow the market or track an index or another benchmark interest rate.
  • Floating rates are also called variable rates.

Understanding Floating Interest Rates

A floating interest rate rises or falls with the rest of the market or along with another benchmark interest rate. The underlying benchmark interest rate or index depends on the type of loan or security, but it is often associated with either the London Interbank Offered Rate (LIBOR), the federal funds rate, or the prime rate (the interest rate financial institutions charge their most creditworthy corporate customers).

When it comes to consumer loans and debt (like for mortgages, car loans, or credit cards), banks and financial institutions charge a spread over this benchmark rate, with the spread depending on several factors, such as the type of asset and the consumer’s credit rating. Thus, a floating rate would define itself as “the LIBOR plus 300 basis points" or "plus 3%."

Floating interest rates may be adjusted quarterly, semiannually, or annually.

All sorts of loans and debt instruments carry floating interest rates. But they tend to be especially common with credit cards and mortgages.

Types of floating-rate products

Home loans that carry floating rates are known as adjustable-rate mortgages (ARMs). 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 Treasury Average (MTA). If an individual takes out an ARM with a 2% margin based on LIBOR, for example, and LIBOR is at 3% when the mortgage's rate adjusts, the rate resets at 5% (the margin plus the index).

Most credit cards charge floating or variable interest rates on unpaid balances. In the credit card agreement that new cardholders receive, it'll state that the card's annual percentage rate (APR) is such-and-such, based on the so-and-so rate or index plus a certain amount, or margin. They'll usually add something like "this APR will vary with the market."

Credit card interest rates are predominantly indexed to the prime rate—which directly reflects the interest rate set by the Federal Reserve several times per year—along with a margin that varies at the card product level and individual account holder's credit quality.

Floating Interest Rate vs. Fixed Interest Rate

A floating interest rate contrasts with a fixed interest rate, in which the interest rate stays constant and doesn't change. It might apply during the entire term of the loan or debt obligation, or for just part of it.

Residential mortgages can be obtained with either fixed or floating interest rates. With fixed interest rates, the mortgage interest rate is static and cannot change for the duration of the mortgage agreement. With floating or variable interests rates, the mortgage interest rates can change periodically with the market.

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.

Example of Floating Interest Rate Loan

Herbert and Amanda are buying a house, and they take out a $500,000, 30-year 7/1 ARM. This means their loan's interest rate is fixed at 2% for seven years. At the end of that time, the mortgage resets to have a floating interest rate, which changes once a year; it is pegged to the LIBOR. So in the eighth year, their interest rate rises to 4%. In the ninth year, the LIBOR rate has dropped slightly, so their interest rate decreases to 3.7%. In the 10th year, it falls again to 3.5%. The interest the couple pays on their mortgage will continue to fluctuate annually this way, until they pay off the mortgage in full—or refinance it.

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.

Of course, the opposite could happen too. The key disadvantage of a floating rate is that the rate may float upward and increase the borrower's monthly payments—even perhaps to the point of making those payments impossible. Overall, a floating rate loan is unpredictable, making it tough to budget cash flow and to calculate the long-term costs of borrowing. And, unless you're the chair of the Fed, the forces governing the changes in the rates are beyond your control.

Advisor Insight

James Di Virgilio, CIMA®, CFP®
Chacon Diaz & Di Virgilio, Gainesville, Florida

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.