Floating Interest Rate – Meaning, Benefit & Calculation

What is Floating Interest Rate?

The interest rate on debt is of two kinds – fixed and floating. If the interest keeps going up or down through the tenure of the debt, depending upon the economic or market situation, it is said to be ‘floating’. Hence the name ‘floating interest rate.’ Usually, a floating interest rate mimics the movement of an index or the market in general. It is also called a ‘variable interest rate’ or ‘adjustable interest rate.’ If the interest rate remains fixed over the tenure of the debt, it is called a fixed interest rate.

How is floating interest rate calculated?

A floating interest rate uses a reference rate as the base. The most popularly used reference rates are the US Prime Rate, the interest on US Treasury Bills, The Federal Funds Rate, and the London Interbank Offered Rate (LIBOR). In order to arrive at the floating rate, a spread (or margin) is added to the reference rate.

Floating Interest Rate = Base Rate + Spread

Floating interest rates can be modified quarterly, half-yearly or annually.

For example, on 21^st March 2023, the Reserve Bank of India (RBI) increased the interest rate of Floating Rate Bonds (FRB 2033) to 8.51% for the period March 2023 to September 2023. The base was calculated as the Weighted Average Yield (WAY) of the last 3 auctions of 182-day Treasury Bills. A fixed spread of 1.22% was added to this reference rate to arrive at 8.51%.

When is floating rate used?

There are many uses of a floating interest rate. It is primarily used in home loans. These loans come with the option of choosing between fixed and floating interest rates. So, if the interest rate of the bank rises, the EMI will commensurately rise and vice versa. Thus, a floating rate should be chosen if the interest rate is expected to drop in the future. Floating rates are also commonplace in the banking industry when corporates borrow money.

Advantages & Disadvantages of Floating Interest Rate

There are upsides as well as downsides to using floating rates. While there is scope for making unexpected potential gains, it is also true that floating rates are essentially a gamble on the market conditions. Here are the pros and cons:

Advantages:

• Floating rates are generally lower than fixed interest rates, and thus help borrowers save on the total cost of debt. However, this is only beneficial for short-term borrowings.
• In the case of mortgage, floating rates come in handy when borrowers choose to sell their assets and repay their debts before the rate re-adjusts.
• With floating interest rates, there is always a chance of benefitting through unforeseen gains. If interest rates drop, the floating rate will ensure that the borrower also pays less interest.

• Since floating interest rates are unpredictable, borrowers are at the mercy of the market conditions. In unfavourable conditions, borrowers may be significantly hit, and hence long-term borrowers must steer clear of floating interest rates.
• The dynamic nature of floating rates also means that there is always the risk of rate re-adjustment between loan repayments. So, a borrower may suddenly have to start paying higher EMIs against their loans.
• The unpredictability of floating rates makes it difficult to budget repayments for the borrower, and makes it harder to anticipate gains for the lender.

Difference between Floating & Fixed Interest Rates

There are a couple of key differences between the two, which borrowers and lenders should be well aware of:

• As the name suggests, a fixed interest rate does not change throughout the tenure of the borrowed loan. So, a home loan borrowed at a fixed interest rate will demand a fixed EMI. On the other hand, in the case of a floating interest rate, the EMI will keep varying with changing interest rates.
• A fixed interest rate does not impact the return on the investment against the loan. However, a fluctuating interest rate results in different repayment amounts and thus influences the return on the investment.
• Investors who prefer to plan and budget their money in advance will prefer a fixed interest rate, as opposed to those who are willing to take some risk. But, with some degree of risk, there is also the potential to benefit from a drop in interest rates.