What Is a Floating Interest Rate?

A floating interest rate is an interest rate 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.

A floating interest rate can also be referred to as an adjustable or variable interest rate because it can vary over the term of a debt obligation.

Understanding Floating Interest Rates

A floating interest rate rises or falls with the rest of the market or along with a benchmark interest rate. The underlying benchmark interest rate or index depends on the type of loan or security, but it is often 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 other debt (e.g., 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 might define itself as “the LIBOR plus 300 basis points" or "plus 3%."

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 (or spread) 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 over the LIBOR, for example, and LIBOR is at 3% when the mortgage's rate adjusts, the mortgage rate resets to 5% (the margin plus the index).

Most credit cards charge floating or variable interest rates on unpaid balances. The credit card agreement that new cardholders receive will state that the card's annual percentage rate (APR) is based on a particular rate or index plus a certain percentage (or margin). The agreement will usually include text such as "this APR will vary with the market."

Floating Interest Rate vs. Fixed Interest Rate

A floating interest rate contrasts with a fixed interest rate. With a fixed interest rate, the rate is constant and doesn't change. It might apply to 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 over the life of the loan.

Example of a Floating Interest Rate Loan

Herbert and Amanda are buying a house. They take out a $500,000, 30-year 7/1 ARM. This means that their loan's interest rate is fixed at, for example, 2% for seven years. At the end of that time, the mortgage resets to a floating interest rate, which changes once a year. The floating rate is pegged to the LIBOR.

In the eighth year, their interest rate rises to 4%, reflecting the LIBOR. In the ninth year, the LIBOR rate has dropped slightly, so their interest rate decreases to 3.7%. In the 10th year, the LIBOR decreases again and the couple's floating interest rate also falls again, to 3.5%. The interest the couple pays on the mortgage will continue to fluctuate annually, until the mortgage is paid off or refinanced.

Advantages and Disadvantages of Floating Rates

Advantages

• Floating rate mortgages 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 their 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.
• Floating interest rates may float down, thus lowering the borrower's monthly payments.

Disadvantages

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

The Bottom Line

A floating interest rate, otherwise known as a variable interest rate, changes periodically in accordance with the benchmark rate to which it's pegged. If the benchmark rate increases, the floating interest rate increases, and vice-versa. If a floating rate drops, borrowers will save money with lower monthly payments. However, if it rises, they'll be faced with having to pay more each month than they had previously. This risk of higher borrowing costs is the floating interest rate's primary disadvantage for borrowers.