What Is a Floating Rate Loan?
Floating Rate Loan Explained
A floating interest rate is also known as an adjustable or variable interest rate. The name comes from the fluidity of the interest rate that borrowers must contend with, as the interest percentage fluctuates throughout the life of the loan (for hybrid ARMs, the rate fluctuates after the introductory period ends). The interest rate is affected by the market’s margins or mortgage index.
Floating interest rates may sound like a rip-off, but in general, they can be much lower than that of a fixed rate due to the risk the borrower is taking in that the rate can increase and result in an increased monthly payment. Typically with a floating rate loan, the initial interest rate is set lower than what a borrower could get from a fixed-rate mortgage loan.
Why Does the Interest Rate Change?
For floating rate loans, the interest rate is based on a market index as determined by the lender. Some popular indexes that lenders refer to are the London Interbank Offered Rate (LIBOR), the prime rate, and different U.S. Treasury bill rates. When entering a variable interest loan agreement, the lender will state which benchmark index your rate is associated with, and assign a margin based off of interest percentage points.
For example, your interest rate could be set at 2 points above the prime rate. If the prime rate is 3.5%, then your interest rate would be 5.5%. It is important to note that the lender’s margin doesn’t change, but the index rate will. If the prime rate in the previous example were to drop to 2.75%, then your interest rate would decrease appropriately to 4.75%.
Interest Rate Caps
Having a floating interest rate seems like a risky move, and while it does involve some uncertainty for the borrower, there are limits as to just how much an interest rate can rise or fall. In most cases, loans with variable interest rates are given interest rate caps. These values are put in place to ensure that a borrower doesn’t get hit with an insane monthly payment out of the blue that might compromise their ability to pay the loan off.
There are two types of interest rate caps that accompany floating interest loans. The first is a cap that dictates how much the borrower’s rate can increase for each adjustment. The cap is typically a percentage, and no matter how much the market fluctuates, your rate cannot be increased any more than that set percentage. The second type of interest rate cap works the same way, however, it represents the maximum amount your interest rate can be raised over the life of the loan. This cap is sometimes referred to as the lifetime interest rate cap.