Floating Interest Rate

Financial Dictionary -> Loans -> Floating Interest Rate

A floating interest rate is an interest rate that moves up or down with a particular index. It is generally comprised of two parts. Part one is the base rate and part two is the margin. It is also called a variable rate or adjustable rate. This rate does not have to have a margin included. In other words, a debt instrument can be tied to an index only with that index rate as the floating interest rate. Either way, the rate floats over the life of the instrument.

Like a fixed rate, a floating interest rate can be applied to any debt instrument. Loans, bonds and mortgages come to mind instantly but in reality any credit instrument can carry a floating interest rate. Usually it is the type of debt that determines what index, or other base rate, will be used for each relevant period. Mortgages using floating interest rates are the ones most commonly using interest rates comprised of a base rate plus a margin. They may use the 12th district Cost of Funds Index and add a fixed margin making it the loan's interest rate.

Mathematically it looks like: COFI = 3.5% Margin = 2.5%. Adding them together equals a rate of 6% for a predetermined period of time.

A most of the time advantage to floating rate loans is that their cost is less than fixed rate loans. This is because the borrower assumes the interest rate risk in exchange for paying a lower loan rate. The borrower is betting the interest rates won't go up and if they do, it won't by a substantial amount.

On the other hand, the term of the loan may be substantially longer than the basis from which the floating rate loan is priced. A 30 year mortgage is a good example. The rate may be priced off a 6 month index. In this scenario, a borrower's rate could change every six months. Although a floating rate might seem like too much of a risk to take, it is the actual circumstances underlying the need for the loan that determine if a floating interest rate is right for you.