What is a Floating Interest Rate and How Does it Work? (With Examples)
Summary:
Floating interest rates change with the market conditions or a benchmark rate set by different financial authorities. They can be lower or higher than fixed interest rates, depending on the benchmark index that they follow. However, they also have more uncertainty and risk than fixed rates. In this article, we will explain what floating interest rates are, how they compare to fixed interest rates, and how to decide which one is more suitable for your loan or investment goals.
How much money do you pay or earn when you borrow or invest money? It depends on the interest rates, which are like the price tags of money. They change with the supply and demand of money, the inflation rate, the economic growth, and the government's monetary policies.
In the financial market, there are two common types of interest rates in the financial market: fixed and floating. Fixed interest rates are like fixed prices. They stay the same throughout the loan or investment period. Floating interest rates, on the other hand, are like flexible prices. They change from time to time based on different benchmarks that reflect the market conditions.
In this blog, we’ll explore more about floating interest rates and how they can benefit borrowers or investors in some scenarios.
What is a floating interest rate?
A floating interest rate doesn't remain the same throughout the life of a loan or investment. It's also known as a variable, adjustable, or flexible interest rate. The reason it changes is due to its link to specific benchmarks or reference rates. These benchmarks are set by financial authorities or other international institutions to accurately represent the current conditions in the money market. The benchmarks influence various financial products. For instance, they determine the rate of interest on loans, savings accounts, mortgages, and even credit cards.
Understanding interest rate benchmarks in India
In India, specific benchmark rates influence various financial products. The table below offers a detailed overview:
| Financial product | Governing benchmark rate | Description |
| Savings account |
|
In India, banks often set the interest on savings accounts based on the RBI's repo rate or their own MCLR. |
| Home loans (Adjustable-rate Mortgages) |
|
Adjustable-rate mortgages (ARM) change rates using preset margins and indices like LIBOR, COFI, or MTA.
|
| Consumer loans |
|
For consumer loans like mortgages, car loans, or credit cards, banks charge a spread over the benchmark rate. This spread varies based on the asset type and the borrower's credit rating. |
| Credit cards | Prime rate | Credit cards usually charge floating interest rates on unpaid balances, based on the bank's prime rate. |
How does a floating interest rate work?
A floating interest rate adjusts based on two key components: the base rate and the margin. The base rate, set by financial institutions or referenced from rates like the LIBOR, mirrors current economic conditions. On top of this, a margin is added, often termed the 'spread' in investment circles, to determine the final rate. The floating rate is updated periodically, be it monthly, quarterly, or annually, to align with market shifts.
You can calculate the floating interest rate using the following formula:
Floating Interest Rate (%) = Base Rate + Margin
For example, if you borrow money from a bank that uses the RBI repo rate as the base rate, and the bank adds a 3% margin, then your floating interest rate is:
Floating interest rate (%) = RBI repo rate + 3%
If the RBI repo rate is 6%, then your floating interest rate is 6% + 3% = 9%. This means you have to pay 9% interest on your loan. If the RBI repo rate changes, your floating interest rate will change too, but the 3% margin will stay the same.
Similarly, if you invest money in a bond that pays a floating interest rate that is linked to the LIBOR as the base rate, and the bond has a 2% margin, then your floating interest rate is:
Floating interest rate (%) = LIBOR + 2%
If the LIBOR is 4%, then your floating interest rate is 4% + 2% = 6%. This means you will receive 6% interest on your bond. If the LIBOR changes, your floating interest rate will change too, but the 2% margin will stay the same.
The process of calculating floating interest rates is similar for both borrowers and investors. The only difference is that borrowers pay interest and investors receive interest
Floating vs. fixed interest rates: What are the key differences?
You have learned about floating interest rates in the previous section. In this section, we will explore fixed interest rates. Both types of interest rates have their own pros and cons. The best choice for you depends on your financial situation, preferences, and long-term goals. To help you make a quick decision, we have compared the two types of interest rates in the table below.
| Parameter | Floating interest rates | Fixed interest rates |
| Flexibility | The interest rate can adjust and potentially benefit from market changes. | The rate is stable and provides certainty in returns or repayments, irrespective of market changes. |
| Risk | Returns or repayments may fluctuate with economic changes. | Returns or repayments are predictable and unaffected. |
| Potential savings or earnings | If the benchmark rate drops, borrowers can save, and investors might earn less. | Borrowers won't benefit from market rate declines, but investors would get guaranteed returns. |
| Suitability | It is suitable for those who are comfortable with some risk. Often chosen for short-term loans, variable-rate mortgages, or volatile investments. | Ideal for long-term mortgages, personal loans, or stable investments. |
| Early exit or change | There are usually fewer penalties for early loan repayment or changing investment positions. | There might be charges or penalties for early loan repayment or exiting an investment. |
Wrapping up: Key points to remember
- A floating interest rate changes over time and isn't fixed for the entire duration of a loan or investment.
- The formula to calculate the floating interest rate is Floating interest rate (%) = Base rate + Spread/Margin.
- Your choice between floating and fixed rates should consider your financial situation, risk tolerance, and goals.
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