Floating Interest Rate
Floating interest rate, also known as variable or adjustable rate, refer to any type of debt instrument, such as a loan, bond, mortgage, or credit, that does not have a fixed rate of interest over the life of the instrument. Instead, the interest rate floats or changes based on a reference rate, such as the Prime Rate or LIBOR. Floating interest rate debt is beneficial for borrowers because the interest rate can go down, resulting in lower monthly payments.
In contrast to fixed-rate debt instruments that charge the same interest rate for the entire loan period, variable interest rate loans utilize a Benchmark Index rate against which changes in the interest rate of the loan will be determined. As long as the loan is in good standing, the rate can only move either up or down. There is usually a cap or floor limit, which limits the maximum or minimum rate that can be charged to the borrower. This allows the borrower to know that even if the Benchmark Index rises, the borrower will not be charged a higher rate than the cap.
Variable interest rate loans can be either fixed-rate or adjustable-rate. Fixed-rate loans are when the rate stays the same for the full duration of the loan, but can still fluctuate based on the Benchmark Index. While these loans may allow the borrower to save money if the Benchmark Index goes down, they also can be more expensive if the Index rises. On the other hand, adjustable-rate loans will fluctuate along with the Benchmark Index rate. This allows the borrower to benefit from any downward movement in the Index while simultaneously freeing them from the financial burden of any upward movement in the Index.
The term “floating interest rate” can be used to describe several different forms of debt instruments. Some floating interest rate instruments come with an initial fixed period, after which the interest rate is reset periodically according to the Benchmark Index. Others are known as hybrid loans, which combine both fixed and variable rates in the same loan. These loans will have a fixed rate for a certain period, and then the rate will switch to a variable rate.
Floating interest rate debt can be beneficial for borrowers in both short-term and long-term scenarios. In the short-term, if the benchmark index remains steady or drops, then the borrower will save in interest payments. In the long-term, if the benchmark index rises and the borrowers rate adjusts upwards, then the borrower can save money if they can pay off the loan before the rate adjusts.
The primary benefit of a floating interest rate loan is that it allows borrowers to be more flexible and can help them save money if the Benchmark Index decreases. However, it is important to understand the risks involved with taking out a floating interest rate loan. The biggest risk is that if the Benchmark Index rises, then the borrower will be left paying a higher rate than what they initially anticipated. Additionally, if the borrower cannot pay off the loan before the rate adjusts, they could be in for a financial shock.
When considering taking out a loan with a floating interest rate, it is important that borrowers weigh the pros and cons carefully. The primary benefit of these loans is the potential to save money when the Benchmark Index is low, but there is always the risk that the rate could rise when it adjusts. Borrowers should understand both the benefits and the associated risks before entering into a loan agreement.
