Information about Floating Interest Rate

In business and finance, floating interest rates, a floating rate, variable rate or adjustable rate refers to any type of loan, bond, mortgage or credit that does not have a fixed rate of interest over the life of the loan. Such loans typically use 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 loans 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.

Example

A customer borrows $100,000 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.