What is Floating Interest Rate?

A floating interest rate is rate that adjusts periodically and reflects changes in the broader financial environment.

In India, floating rates are commonly associated with loans whose interest rates are linked to external benchmarks or internal lending benchmarks, depending on the type of borrower and loan. Changes in the monetary policy environment, market conditions and benchmark rates can therefore influence the interest paid by borrowers.

An interest rate is the cost of borrowing money or the return earned from lending or investing money. It is expressed as a percentage of the principal amount over a specific period, usually one year.

For borrowers, the interest rate represents the cost paid to a lender for using borrowed funds. For investors, interest is the income earned on money deposited in a bank or financial institution, or on any interest-bearing asset.

This comprehensive guide explains what floating rates are, how they are calculated, their relevance to borrowers and investors, the factors that affect rates, and their advantages and disadvantages.

What are Floating Interest Rates?

Floating interest rates are interest rates that change over the tenure of a loan or any financial product. Unlike fixed rates, which remain unchanged for the agreed period, a floating rate moves with changes in benchmark rates.

The Reserve Bank of India (RBI) repo rate is one important benchmark for floating-rate loans in India, although the applicable benchmark depends on the loan and lender.

This policy rate serves as a foundational reference point for the economy and commercial bank lending.

The floating rate is widely used in loans such as home loans, business loans and other forms of credit. When benchmark rates change, the lender may revise the applicable rate in accordance with the loan agreement.

Also read: Fixed vs Floating Interest Rates

How are Floating Interest Rates Calculated?

Floating interest rates are generally calculated by adding a lender-determined fixed spread or margin to a benchmark rate.

The benchmark is the reference interest rate used to determine the lending rate, while the spread is the additional margin charged by the lender based on factors such as the borrower’s profile, loan type, and credit risk.

Floating Interest Rates Formula:

Floating Interest Rate = Benchmark Rate + Spread or Margin.

The calculation process works as follows:

• Identify the benchmark rate, such as the repo rate or any other market-linked rate.
• Add the lender’s applicable spread based on loan type and credit profile.
• Add both to determine the effective interest rate.
• Review the rate periodically, monthly or quarterly, or as specified in the loan agreement or applicable reset schedule.
• Adjust the rates in response to changes in the benchmark rate.

Example:

• Benchmark rate = 6.5%
• Lender spread = 2%

Therefore,

• Floating interest rate = 6.5% + 2%
• Floating interest rate = 8.5%.

Suppose that, after one quarter, the benchmark rates decline by 0.25 points.

• The new benchmark rate is 6.5% - 0.25% = 6.25%
• Therefore, the floating interest rate also declines by 0.25%.
• New floating rate = 6.25% + 2% = 8.25%.

Also read: How Changes in Repo Rate Impact Your Investments?

When are Floating Rates Relevant?

Floating rates are used when the applicable interest rate is expected to change in response to market or benchmark conditions. They are particularly relevant to borrowing and certain investment products.

Applying for a Loan

Here are scenarios when floating rates are relevant:

• Home Loans:

Floating interest rates are available for home loans, allowing the loan rate to change when the applicable benchmark changes.

• Business Loans:

Businesses may use floating-rate loans in which borrowing costs are linked to prevailing benchmark rates and lending conditions.

• Personal Loans:

Some personal credit products may have variable pricing, though availability and structure depend on the lender and product.

• Long-Term Borrowing:

Floating rates can be suitable for longer-term loans because borrowers participate in both rising and falling interest-rate cycles.

• Rate Sensitive Borrowing:

Borrowers expecting interest rates to decline may prefer floating rates because future rate reductions can lower borrowing costs.

Investing

Here is how floating rates are relevant while investing:

• Floating Rate Bonds:

Certain bonds and debt instruments offer returns linked to a benchmark, allowing interest payments to change periodically.

• Debt Funds:

Certain debt investment strategies are centred around securities whose coupons reset with prevailing interest rates.

• Interest Rate Sensitive Securities:

Investors can use floating-rate instruments to manage exposure to changing interest rates.

• Portfolio Diversification:

Floating-rate investments can provide diversification when an investor seeks exposure to instruments whose returns adjust with interest rates.

Factors Affecting Floating Interest Rates

Several economic and financial factors influence floating interest rates in India.

• RBI Monetary Policy

RBI policy decisions influence the broader interest rate environment by affecting the cost and availability of funds in the financial system.

• Inflation

Higher inflation can influence monetary policy decisions and may contribute to higher interest rates when regulators seek to control price pressures.

• Liquidity

Changes in banking system liquidity can affect funding conditions and consequently influence market and lending rates.

• Economic Growth

Strong economic growth can increase credit demand, while weaker growth may reduce borrowing demand and influence lending conditions.

• Benchmark Rates

Movements in the benchmark to which a loan or investment is linked directly affect the applicable floating interest rate.

• Credit Risk

A borrower’s credit profile can influence the spread charged over the benchmark, particularly where lender pricing depends on borrower-specific risk.

• Global Interest Rates

International interest rate movements can influence financial markets, capital flows and broader borrowing conditions in India.

Fixed vs Floating Interest Rates

Here are the key differences between fixed vs floating interest rates:

How do Floating Rates Impact Investors?

Floating rates can influence investors in several ways, particularly those holding interest-sensitive investments.

• Changing Interest Income

Floating rate investments can generate higher or lower interest income as the underlying benchmark changes.

• Protection Against Rising Rates

Investments with rates that reset periodically can potentially provide better income when market interest rates rise.

• Lower Risk of Being Locked Into Low Rates

Floating rate instruments can adjust their returns periodically, which can reduce the risk of being locked into a low rate for an extended period.

• Portfolio Diversification

Investors can use floating-rate securities as part of a diversified portfolio to gain exposure to changing interest-rate conditions.

• Market Value Impact

Changes in interest rates can affect the market value and attractiveness of debt securities, although the impact varies depending on the instrument’s structure and duration.

How do Floating Rates Impact Loans?

Changes in floating rates can directly affect the cost and repayment structure of loans.

• EMI Changes

A rise in the floating interest rate can increase the EMI if the loan structure passes the change directly to monthly repayments.

• Loan Tenure Changes

Instead of increasing the EMI, a lender may adjust the repayment tenure following an interest rate change, depending on the loan terms.

• Lower Cost During Rate Cuts

When interest rates decline, borrowers may benefit from lower EMIs, reduced interest costs, or a shorter repayment period.

• Higher Cost During Rate Hikes

When floating rates increase, borrowers may pay more interest over the remaining tenure of the loan.

• Uncertainty

Borrowers cannot always predict their future repayment costs because the applicable interest rate can change over the loan term.

Advantages of Floating Interest Rates

Here are some common advantages of floating interest rates:

• Benefit from Falling Rates

Borrowers can benefit from reductions in benchmark rates because their applicable floating interest rate may decline.

• Lower Initial Rates

Floating-rate loans may sometimes offer competitive initial rates compared with certain fixed-rate products, depending on market conditions.

• Suitable for Long-Term Loans

Floating rates can be useful for long-term borrowing because they allow borrowers to participate in interest-rate cycles.

• Market-Linked Pricing

Floating rates are linked to benchmarks, making the pricing mechanism more responsive to changes in the broader financial environment.

• Potential Interest Savings

When interest rates remain stable or decline, borrowers may potentially save interest compared with a higher fixed rate over the same period.

Disadvantages of Floating Interest Rates

Here are some common disadvantages of floating interest rates:

• EMI Uncertainty

Rising floating rates can increase the borrower’s EMI or alter the repayment tenure, making long-term budgeting more difficult.

• Higher Interest Costs

A sustained increase in interest rates can significantly increase the total interest payable on a loan.

• Market Dependency

Floating rates are affected by benchmark movements and broader economic conditions that individual borrowers cannot control.

• Budgeting Challenges

Future borrowing costs can be difficult to estimate because the applicable rate may change several times during the loan tenure.

• Risk During Rising Rate Cycles

Borrowers can face financial pressure when monetary tightening or other market developments cause interest rates to rise.

How to Choose Between Floating and Fixed Rates?

The choice between floating and fixed rates depends on a borrower’s financial situation, risk tolerance, loan tenure and expectations about future interest rates.

A borrower who values predictable repayments may prefer a fixed rate, particularly when certainty is more important than the possibility of benefiting from future rate cuts.

A borrower who is comfortable with rate fluctuations and believes interest rates may decline could consider a floating rate. However, the borrower must also be financially prepared for higher rates.

Loan tenure is another important consideration. A longer tenure increases exposure to interest rate changes because the borrower remains subject to the rate environment for a longer period.

Borrowers should compare the total expected cost rather than selecting a loan solely because its initial interest rate appears lower.

FAQs

What is a floating rate?

A floating rate is an interest rate that changes periodically in response to movements in a benchmark or reference rate. It is commonly used for loans and investments, allowing the applicable interest rate to rise or fall with prevailing market conditions.

What is the difference between floating and fixed interest rates?

A floating interest rate changes periodically in line with a benchmark, while a fixed interest rate remains unchanged for the agreed period. Floating rates offer potential benefits when rates fall but involve uncertainty, whereas fixed rates provide greater repayment predictability.

Does EMI change with a floating rate?

Yes, EMI can change when a floating interest rate changes, depending on the lender’s repayment mechanism. When rates rise, EMI may increase, or the loan tenure may extend. When rates fall, EMI may decrease, or the tenure may be reduced.

How to calculate a floating rate?

A floating interest rate is generally calculated by adding the lender’s spread or margin to the applicable benchmark rate. The formula to calculate a floating rate is: Floating rate = Fixed spread + Benchmark rate.

How to check whether the loan is floating or fixed?

Check the loan agreement, sanction letter or lender’s statement to identify whether the interest rate is fixed or floating. Look for terms such as benchmark, reset frequency, spread or rate revision. You can also confirm the rate type directly with your lender.