If you are considering taking a loan or investing in a financial product, it's essential to understand the different types of interest rates available to you. Two principal types include fixed and floating rates. While fixed interest rates remain constant over time, floating interest rates can fluctuate based on a range of factors, such as changes in the market or economic conditions. This blog explains what a floating interest rate means.
What is a Floating Rate?
A floating rate is a variable interest rate based on underlying benchmark or reference rate changes. Typically, the benchmark used for a floating rate is a widely recognised financial index, such as the Repo Rate. The interest rate on a loan or financial product tied to a floating rate will change in response to movements in this benchmark rate. For example, if the benchmark rate increases, the floating rate will also increase, and vice versa.
Floating Rate Calculation
The floating rate calculation depends on the specific financial product and the benchmark rate. In general, the formula for calculating a floating interest rate is:
Floating rate = Benchmark rate + Spread
The spread is an additional amount added to the benchmark rate to determine the final interest rate. A Floating interest rate example is if the benchmark rate is currently 3%, and the spread is 2%, the floating rate would be 5% (3% + 2%).
When is a Floating Interest Rate Relevant?
Floating interest rates are relevant where the borrower or investor seeks flexibility or wants to manage interest rate risk. Here are some common scenarios where floating interest rates can be applied.
1. Adjustable-rate mortgages (ARMs)
ARMs generally have a fixed interest rate for an initial period and then switch to a floating interest rate that adjusts periodically based on market conditions. This is suitable for borrowers who expect their income to increase in time and can handle the risk of their mortgage payments increasing over time.
2. Variable-rate loans
Like ARMs, variable-rate loans have a floating interest rate that can change over time. These loans can be appropriate for borrowers who want flexibility in their payments and can manage the risk of interest rates increasing.
Certain types of bonds, such as floating-rate notes, have interest rates that adjust periodically based on changes in a benchmark rate. These bonds can be useful for investors who hedge against inflation or interest rate risk.
4. Savings accounts and CDs
Some savings accounts and certificates of deposit (CDs) may offer floating interest rates that change based on market conditions. This can benefit savers who want to earn a higher interest rate but don't want to commit to a fixed rate for an extended period.
Benefits of Floating Interest Rate
Floating interest rates offer several benefits for borrowers and investors.
1. Flexibility: Floating interest rates provide borrowers and investors with flexibility as they can adjust according to market conditions.
2. Potentially lower initial rates: Floating interest rates may start lower than fixed rates, making them more attractive to borrowers or investors looking for lower initial payments or higher returns.
3. Ability to take advantage of falling rates: If the benchmark rate decreases, the floating interest rate will also decrease, leading to lower interest payments or borrowing costs for investors.
4. Potential to earn higher returns: If the benchmark rate increases, the floating interest rate will also increase, leading to higher returns for investors who hold floating-rate securities or deposits.
5. Avoidance of prepayment penalties: Floating interest rates are often associated with adjustable-rate mortgages or variable-rate loans that don't have prepayment penalties. This can be useful for borrowers looking to pay off their loans early or refinance when interest rates are low.
Limitations of Floating Interest Rate
While floating interest rates offer several benefits, some limitations and risks are associated.
1. Uncertainty: Floating interest rates can be unpredictable and fluctuate based on market conditions, making it difficult for borrowers or investors to plan their finances.
2. Risk of rising rates: If the benchmark rate increases, the floating interest rate will also increase, leading to higher payments for borrowers or higher borrowing costs for investors.
3. Potentially higher overall costs: While floating interest rates may start lower than fixed rates, they can also increase over time and lead to higher overall costs for borrowers or investors.
4. Limited options: Floating interest rates are not always available for all types of loans or investments, which can limit the options available to borrowers or investors.
5. Refinancing risk: If interest rates increase significantly, borrowers with floating-rate loans may find it difficult to refinance their loans or may face prepayment penalties if they choose to refinance.
Who Should Opt for a Floating Interest Rate?
Deciding whether to opt for a floating interest rate or not depends on the individual borrower or investor's financial situation, risk tolerance, and goals. Here are some scenarios where a floating interest rate may be suitable.
1. Short-term borrowers: Borrowers who plan to repay their loan in the short term may find a floating interest rate more appealing. This way, they can take advantage of potentially lower initial rates and avoid prepayment penalties associated with fixed-rate loans.
2. Investors looking for higher returns: Investors willing to take on higher risk and earn higher returns may opt for floating-rate investments such as bonds or mutual funds that invest in floating-rate securities.
3. Borrowers with uncertain future income: Borrowers who expect their income to increase in the future or those who have variable income may find a floating interest rate more suitable as it offers more flexibility than a fixed rate.
4. Borrowers who want to hedge against inflation: Borrowers concerned about inflation and want to protect their purchasing power may choose a floating interest rate that adjusts with inflation.
5. Investors who want to hedge against interest rate risk: Investors who are worried about rising interest rates and want to hedge against interest rate risk may consider floating-rate investments such as floating-rate notes or floating-rate mutual funds.
Differences Between Floating and Fixed Interest Rates
The main differences between floating and fixed interest rates are:
Unpredictable and may change based on market conditions.
Offers more predictability for borrowers or investors as they know exactly what their payments or returns will be throughout the loan or investment term.
Start lower than fixed rates, but they can increase over time.
Start higher than floating interest rates as they offer more predictability and stability.
Carry more risk.
Less risky due to certainty.
Often do not carry prepayment penalties.
Carry prepayment penalties if the borrower pays off the loan before the end of the term.
Fixed interest rates offer more predictability and stability whereas floating interest rates provide more flexibility and the potential for lower initial rates. Borrowers and investors should consider their financial goals, risk tolerance, and market conditions when deciding whether to opt for a fixed or floating interest rate.