Floating interest rate

Floating interest rate

A floating interest rate, also known as a variable rate or adjustable rate, refers to any type 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.

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 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.

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 loans, although they are distinct concepts. In a bullet loan, a large payment (the "bullet") is payable at the end of the loan. A floating rate loan may or may not incorporate a bullet payment.


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.

Wikimedia Foundation. 2010.

Игры ⚽ Поможем написать курсовую

Look at other dictionaries:

  • floating interest rate — n. A variable interest rate that changes based on the money market. The Essential Law Dictionary. Sphinx Publishing, An imprint of Sourcebooks, Inc. Amy Hackney Blackwell. 2008 …   Law dictionary

  • Floating Interest Rate — An interest rate that is allowed to move up and down with the rest of the market or along with an index. This contrasts with a fixed interest rate, in which the interest rate of a debt obligation stays constant for the duration of the agreement.… …   Investment dictionary

  • floating interest rate — interest rate that changes according to the market s buyers …   English contemporary dictionary

  • floating interest rate — Rate of interest that is not fixed but which varies depending upon the existing rate in the money market …   Black's law dictionary

  • floating interest rate — Rate of interest that is not fixed but which varies depending upon the existing rate in the money market …   Black's law dictionary

  • Floating exchange rate — Floating rate may also refer to a floating interest rate applied to a loan or other lending product. A floating exchange rate or a flexible exchange rate is a type of exchange rate regime wherein a currency s value is allowed to fluctuate… …   Wikipedia

  • Interest rate risk — is the risk (variability in value) 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. Interest rate risk is… …   Wikipedia

  • Interest rate derivative — An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given interest rate.The interest rate derivatives market is the largest derivatives market in the… …   Wikipedia

  • Interest-Rate Derivative — A financial instrument based on an underlying financial security whose value is affected by changes in interest rates. Interest rate derivatives are hedges used by institutional investors such as banks to combat the changes in market interest… …   Investment dictionary

  • Interest Rate Call Option — An interest rate derivative in which the holder has the right to receive an interest payment based on a variable interest rate, and then subsequently pays an interest payment based on a fixed interest rate. If the option is exercised, the… …   Investment dictionary

Share the article and excerpts

Direct link
Do a right-click on the link above
and select “Copy Link”