Floating interest rate
Encyclopedia
A floating interest rate, also known as a variable rate or adjustable rate, refers to any type of debt
instrument, such as a loan
, bond
, mortgage
, or credit, that does not have a fixed rate
of interest
over the life of the instrument.
Such debt typically uses an index
or other base rate for establishing the interest rate for each relevant period. One of the most common rates to use as the basis for applying interest rates is the London Inter-bank Offered Rate, or LIBOR (the rates at which large banks lend to each other).
The rate for such debt will usually be referred to as a spread
or margin
over the base rate: for example, a five-year loan may be priced at six-month LIBOR + 2.50%. At the end of each six-month period, the rate for the following period will be based on LIBOR at that point (the reset date), plus the spread. The basis will be agreed between the borrower and lender, but 1, 3, 6 or 12 month money market rates are commonly used for commercial loans.
Banks may prefer to lend to their customers with floating rates, since they are raising funds (through deposits, bond issues, and by borrowing from other banks or the money market
). Pricing loans to their customers in the same currency and basis allows banks to manage the balance between their assets and liabilities.
Typically, floating rate loans will cost less than fixed rate loans, depending in part on the yield curve
. In return for paying a lower loan rate, the borrower takes the interest rate risk
: the risk that rates will go up in future. In cases where the yield curve is inverted yield curve, the cost of borrowing at floating rates may actually be higher; in most cases, however, lenders require higher rates for longer-term fixed-rate loans, because they are bearing the interest rate risk
(risking that the rate will go up, and they will get lower interest income than they would otherwise have had).
Certain types of floating rate loans, particularly mortgages, may have other special features such as interest rate caps, or limits on the maximum interest rate or maximum change in the interest rate that is allowable.
or margin
is added (or more rarely, subtracted). The term
of the loan may be substantially longer than the basis
from which the floating rate loan is priced; for example, a 25-year mortgage may be priced off the 6-month prime lending rate.
Floating rate loans are common in the banking industry and for large corporate customers. A floating rate mortgage
is a mortgage with a floating rate, as opposed to a fixed rate loan
.
In many countries, floating rate loans and mortgages predominate. They may be referred to by different names, such as an adjustable rate mortgage
in the United States
. In some countries, there may be no special name for this type of loan or mortgage, as floating rate lending may be the norm. For example, in Canada substantially all mortgages are floating rate mortgages; borrowers may choose to "fix" the interest rate for any period between six months and ten years, although the actual term of the loan may be 25 years or more.
Floating rate loans are sometimes referred to as bullet loan
s, although they are distinct concepts. In a bullet loan, a large payment (the "bullet" or "balloon") is payable at the end of the loan. A floating rate loan may or may not incorporate a bullet payment.
Interest rates option can hedge the floating rate loan.
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
instrument, such as a loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
, bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, or credit, that does not have a fixed rate
Fixed interest
A fixed interest rate loan is a loan where the interest rate doesn't fluctuate during the fixed rate period of the loan. This allows the borrower to accurately predict their future payments...
of interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
over the life of the instrument.
Such debt typically uses an index
Reference rate
A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. It is often some form of LIBOR rate, but it can take many forms, such as a consumer price index, a house price index or an unemployment rate...
or other base rate for establishing the interest rate for each relevant period. One of the most common rates to use as the basis for applying interest rates is the London Inter-bank Offered Rate, or LIBOR (the rates at which large banks lend to each other).
The rate for such debt will usually be referred to as a spread
Spread
Spread may refer to:*Statistical dispersion*Spread , an edible paste put on other foods*the score difference being wagered on in spread betting*the measure of line inclination in rational trigonometry...
or margin
Margin
Margin may refer to:*Margin *Margin , a type of financial collateral used to cover credit risk*Margin , the white space that surrounds the content of a page...
over the base rate: for example, a five-year loan may be priced at six-month LIBOR + 2.50%. At the end of each six-month period, the rate for the following period will be based on LIBOR at that point (the reset date), plus the spread. The basis will be agreed between the borrower and lender, but 1, 3, 6 or 12 month money market rates are commonly used for commercial loans.
Banks may prefer to lend to their customers with floating rates, since they are raising funds (through deposits, bond issues, and by borrowing from other banks or the money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
). Pricing loans to their customers in the same currency and basis allows banks to manage the balance between their assets and liabilities.
Typically, floating rate loans will cost less than fixed rate loans, depending in part on the yield curve
Yield curve
In finance, the yield curve is the relation between the interest rate and the time to maturity, known as the "term", of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S...
. In return for paying a lower loan rate, the borrower takes the interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
: the risk that rates will go up in future. In cases where the yield curve is inverted yield curve, the cost of borrowing at floating rates may actually be higher; in most cases, however, lenders require higher rates for longer-term fixed-rate loans, because they are bearing the interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
(risking that the rate will go up, and they will get lower interest income than they would otherwise have had).
Certain types of floating rate loans, particularly mortgages, may have other special features such as interest rate caps, or limits on the maximum interest rate or maximum change in the interest rate that is allowable.
Floating rate loan
In business and finance, a floating rate loan (or a variable or adjustable rate loan) refers to a loan with a floating interest rate. The total rate paid by the customer "floats" in relation to some base rate, to which a spreadSpread
Spread may refer to:*Statistical dispersion*Spread , an edible paste put on other foods*the score difference being wagered on in spread betting*the measure of line inclination in rational trigonometry...
or margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
is added (or more rarely, subtracted). The term
Time
Time is a part of the measuring system used to sequence events, to compare the durations of events and the intervals between them, and to quantify rates of change such as the motions of objects....
of the loan may be substantially longer than the basis
Basis
Basis may refer to* Cost basis, in income tax law, the original cost of property adjusted for factors such as depreciation.* Basis of futures, the value differential between a future and the spot price...
from which the floating rate loan is priced; for example, a 25-year mortgage may be priced off the 6-month prime lending rate.
Floating rate loans are common in the banking industry and for large corporate customers. A floating rate mortgage
Adjustable rate mortgage
A variable-rate mortgage, adjustable-rate mortgage , or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable...
is a mortgage with a floating rate, as opposed to a fixed rate loan
Fixed interest
A fixed interest rate loan is a loan where the interest rate doesn't fluctuate during the fixed rate period of the loan. This allows the borrower to accurately predict their future payments...
.
In many countries, floating rate loans and mortgages predominate. They may be referred to by different names, such as an adjustable rate mortgage
Adjustable rate mortgage
A variable-rate mortgage, adjustable-rate mortgage , or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable...
in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
. In some countries, there may be no special name for this type of loan or mortgage, as floating rate lending may be the norm. For example, in Canada substantially all mortgages are floating rate mortgages; borrowers may choose to "fix" the interest rate for any period between six months and ten years, although the actual term of the loan may be 25 years or more.
Floating rate loans are sometimes referred to as bullet loan
Bullet loan
In banking and finance, a bullet loan is a loan where a payment of the entire principal of the loan, and sometimes the principal and interest, is due at the end of the loan term. Likewise for bullet bond...
s, although they are distinct concepts. In a bullet loan, a large payment (the "bullet" or "balloon") is payable at the end of the loan. A floating rate loan may or may not incorporate a bullet payment.
Example
A customer borrows $50,000 from a bank; the terms of the loan are (six-month) LIBOR + 3.5%. At the time of issuing the loan, the LIBOR rate is 2.5%. For the first six months, the borrower pays the bank 6% annual interest: in this simplified case, $3,000. At the end of the first six months, the LIBOR rate has risen to 4%; the client will pay 7.5% (or $3,750) for the second half of the year. At the beginning of the second year, the LIBOR rate has now fallen to 1.5%, and the borrowing costs are $2,500 for the following six months.Interest rates option can hedge the floating rate loan.