What is a floating interest rate?
A floating interest rate is an interest rate that goes up and down with the rest of the market or with an index. It can also be called a variable interest rate because it can vary over the term of the debt. This contrasts with a fixed interest rate, in which the interest rate on a debt security remains constant over the life of the loan.
Key points to remember
- Variable rates are carried by credit card companies and are generally seen with mortgages.
- Floating rates follow the market or follow an index.
- Floating rates are also called variable rates.
Understanding floating interest rates
Residential mortgages can be obtained with fixed interest rates, which are static and cannot change during the term of the mortgage contract, or with a floating or adjustable interest rate, which changes periodically with the market.
Most credit cards have floating interest rates.
For example, if someone takes out a fixed rate mortgage with an interest rate of 4%, they pay that rate for the duration of the loan and their payments are the same for the duration of the loan. On the other hand, if a borrower contracts a variable rate mortgage, he can start with a rate of 4% and then adjust, up or down, thus modifying the monthly payments.
In most cases, variable rate mortgages (ARMs) have rates that adjust according to a predefined margin and a major mortgage index such as Libor, the cost of funds index (COFI) or the monthly treasury average (MTA). For example, if someone signs an ARM with a 2% margin based on the Libor, and the Libor is at 3% when the mortgage rate adjusts, the rate resets to 5% (the margin plus the index).
The pros and cons of floating rates
With mortgages, variable rate mortgages generally have lower introductory interest rates than fixed rate mortgages, which can make them more attractive to some borrowers, especially for borrowers who plan to sell. property and repay the loan before the rate adjusts or for borrowers who expect their equity to rise rapidly as the value of homes increases.
The other benefit is that floating interest rates can float, thereby reducing the borrower’s monthly payments. The main drawback, however, is that the rate can float upward and increase the borrower’s monthly payments.
James Di Virgilio, CIMA®, CFP®
Chacon Diaz & Di Virgilio, Gainesville, FL
When it comes to long-term borrowing, it’s best to stay away from a variable rate or any type of variable loan, and this is especially true when interest rates are very low as they are. currently.
It is important to be able to plan exactly what your debt will cost so that you can budget how you will pay it off without surprises.
When you choose to use an adjustable rate loan, you are basically betting that interest rates will be lower in the future. In a changing interest rate environment, each year could result in a potentially higher new interest rate, which could significantly increase the amount of interest you have to pay.
When rates are historically low like today, there is a very good chance that rates will go up in the future and not go down, making an adjustable rate loan a very bad choice because there is practically no real benefit. Therefore, using a fixed rate loan, especially in our current interest rate environment, is the wise decision.
Mortgages are not the only type of loan that can have floating interest rates. Most credit cards also have floating interest rates. As with mortgages, these rates are linked to an index and, in most cases, the index is the current prime rate, the rate which directly reflects the interest rate set by the Federal Reserve several times a year. Most credit card agreements state that the interest rate charged to the borrower is the prime rate plus a certain spread.