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A floating interest rate, also known as a variable or adjustable rate, refers to any type of
debt Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to ...

debt
instrument, such as a
loan In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money avai ...
,
bond Bond or bonds may refer to: Common meanings * Bond (finance) In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of ...
,
mortgage A mortgage loan or simply mortgage () is a loan In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc. The recipient (i.e., the borrower) incurs a ...
, or credit, that does not have a fixed rate of
interest In and , interest is payment from a or deposit-taking financial institution to a or depositor of an amount above repayment of the (that is, the amount borrowed), at a particular rate. It is distinct from a which the borrower may pay the len ...

interest
over the life of the instrument. Floating interest rates typically change based on a
reference rateA 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 consum ...
(a benchmark of any financial factor, such as the
Consumer Price Index#REDIRECT consumer price index A consumer price index measures changes in the price level of a weighted average market basket of Goods, consumer goods and Services marketing, services purchased by households. A CPI is a statistical estimate con ...
). One of the most common reference rates to use as the basis for applying floating interest rates is the London Inter-bank Offered Rate, or
LIBOR The London Inter-Bank Offered Rate is an interest-rate average calculated from estimates submitted by the leading banks in London London is the and of and the . It stands on the in south-east England at the head of a down to the , ...
(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 the six-month LIBOR + 2.50%. At the end of each six-month period, the rate for the following period will be based on the 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. Typically, floating rate loans will cost less than fixed rate loans, depending in part on the
yield curve In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money avai ...

yield curve
. In return for paying a lower loan rate, the borrower takes the
interest rate risk Interest rate risk is the risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, we ...
: the risk that rates will go up in future. In cases where the , 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 is the risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, we ...
(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 varies, or "floats", in relation to some base rate, to which a spread 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 A prime rate or prime lending rate is an interest rate used by banks, usually the interest rate at which banks lend to customers with good credit. Some Floating interest rate, variable interest rates may be expressed as a percentage above or below p ...
. 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 are predominant. They may be referred to by different names, such as an
adjustable rate mortgage A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan A mortgage loan or simply mortgage () is a loan In finance, a loan is the lending of money by one or more individuals, organizations, or oth ...
in the
United States The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country Continental United States, primarily located in North America. It consists of 50 U.S. state, states, a Washington, D.C., ...

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 loanIn banking and finance, a bullet loan is a loan where a payment of the entire principal Principal may refer to: Title or rank * Principal (academia) The principal is the chief executive and the chief academic officer of a university A univers ...
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, as opposed to a capital and interest loan, where the payment pattern incorporates level payments throughout the loan, each containing an element of capital, and no bullet payment at the end. A floating rate loan therefore may or may not incorporate a bullet payment.


Example

A customer borrows $25,000 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 $750 for six months. At the end of the first six months, the LIBOR rate has risen to 4%; the client will pay 7.5% (or $937.5) 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 $500 for the following six months. Interest rates options can hedge the floating rate loan - for example, an interest rate cap ensures a borrower's future interest cash flows will not exceed a certain predefined level.


See also

*
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. Variable rate loans, by contrast, are anchored to the ...


References

{{DEFAULTSORT:Floating Interest Rate Banking Interest rates Loans