Floating interest rate

A floating interest rate, also known as a variable 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.[1]

Floating interest rates typically change based on a reference rate (a benchmark of any financial factor, such as the Consumer Price Index).[1] 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 rates at which large banks lend to each other).[2]

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 return for paying a lower loan rate, the borrower takes the interest rate risk: the risk that rates will go up in future.[3] In cases where the yield curve is inverted, 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 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.

Floating rate loans are common in the banking industry and for large corporate customers.[4][5] A floating rate mortgage is a mortgage with a floating rate, as opposed to a fixed rate loan.[6]

In many countries, floating rate loans and mortgages are predominant. 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" 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.

An Interest rate option contract can hedge the floating rate loan - for example, an interest rate cap and floor ensures a borrower's future interest cash flows will not exceed a certain predefined level.

LIBOR was discontinued as the conventional floating interest rate on December 31, 2021.[7]

In the United States, SOFR (Secured Overnight Financing Rate)[8] has been accepted as the industry standard after the cessation of basing floating interest rate spreads on LIBOR. The transition from LIBOR to SOFR has been relatively uneventful, and SOFR has been adapted by many industries as a standard instrument for determining non-fixed interest rates.

See also

References
  1. "A Guide to Understanding Floating-Rate Securities". Raymond James Financial. Retrieved 16 February 2015.
  2. Zibel, Alan (30 September 2008). "Q&A: What is Libor, and how does it affect you?". The Seattle Times. Retrieved 16 February 2015.
  3. Hoffmann, Peter; Langfield, Sam; Pierobon, Federico; Vuillemey, Guillaume (31 August 2019). "Who Bears Interest Rate Risk?". Review of Financial Studies. {{cite journal}}: Cite journal requires |journal= (help)
  4. Schrimpf, Andreas; Sushko, Vladyslav (31 March 2019). "Beyond LIBOR: a primer on the new reference rates" (PDF). BIS Quarterly Review. Retrieved 23 November 2022.
  5. Nesbitt, Stephen (30 June 2022). "Private Debt: Weathering Rising Interest Rates". Cliffwater. Retrieved 23 November 2022.
  6. Merrefield, Clark (9 November 2022). "Adjustable-rate mortgages: A research-based explainer". The Journalist’s Resource. Retrieved 23 November 2022.
  7. "The deadline for replacing LIBOR looms". NPR. 21 October 2021.
  8. "Secured Overnight Financing Rate Data". New York Fed. Retrieved November 23, 2022.
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