A floating interest rate is an interest rate that is periodically adjusted to reflect changing conditions in the market. Loans with floating interest rates thus have interest that will vary over the life of the loan, and the term “variable rate” is sometimes used. There are advantages and disadvantages to a floating rate for both lenders and borrowers and these must be weighed when applying for a loan or refinance.
Typically, a floating interest rate is based on an index or benchmark rate. The terms of the loan will disclose the index being used to determine the interest rate. The lender also charges a spread, additional percentage points above the index rate. For example, a loan may be advertised as “prime plus 2.5%,” meaning that if the prime rate is 3.5%, the borrower will be paying 6% interest. In rare cases, the spread may be a subtraction rather than an addition, depending on the terms of the loan.
The clear advantage to a floating interest rate is that when interest rates go down, the borrower can access a lower rate. This means that the borrower will pay less to service the loan during periods of low rates. However, this is also a disadvantage, because when rates increase, so does the interest on the loan. By contrast, a loan with a fixed interest rate has a rate that will remain steady for the life of the loan.
If interest rates are high while a person is applying for a loan, it can be advantageous to select a loan with a floating interest rate. Later on, it may be possible to refinance or lock the loan at a lower rate. Borrowers interested in pursuing this option can get information when the loan is originated about how to lock, consolidate, or refinance loans in order to access a lower rate. If interest rates are low, it may be advisable to select a fixed rate loan in order to take advantage of the low rates.
With a floating interest rate, there are periodic reset dates associated with the loan. The loan may reset every time the index rate changes, or it may reset at scheduled intervals, such as annually. This information is disclosed in the loan paperwork so that borrowers know when to expect changes in the terms of their loans. When the interest rate resets, the monthly payments due may also change to keep the borrower on track for repayment.