It is difficult to decide what is the best form of interest when seeking a loan or mortgage. The options can oftentimes be overwhelming and strenuous to navigate. Fixed, APR, compound, simple, and floating interest are just a few options to choose from. Floating interest, also known as variable interest, changes according to the market or an index over the period of the loan. Is floating interest the best option for your loan or mortgage?
The breakdown of floating interest
The change in interest rate with a floating rate loan is typically based on a reference, or “benchmark”, rate that is outside of any control by the parties involved in the contract. The reference rate is usually a recognized benchmark interest rate, such as the prime rate, which is the lowest rate that commercial banks charge their most creditworthy customers for loans (typically, large corporations or high net worth individuals). Floating interest rate debt often costs less than fixed-rate debt, depending on the yield curve. In compensation for lower fixed rate costs, borrowers must bear a higher interest rate risk. Interest rate risk, for bonds, refers to the risk of rates rising in the future. When the yield curve is inverted, then the cost of debt with floating interest rates may be higher than fixed-rate debt. However, an inverted yield curve is the exception rather than the norm.
When are the commonly used times for floating interest?
Floating interest rates are used most commonly in mortgage loans. A reference rate or index is followed, with the floating rate calculated as, for example, “the prime rate plus 1%”. Credit card companies may also offer floating interest rates. Again, the floating interest rate charged by the bank is usually the prime rate plus a certain spread. These are just a few examples of times to consider floating interest!
What are advantages to floating interest?
Generally, floating interest rates are lower compared to the fixed ones, hence, helping in reducing the overall cost of borrowing for the debtor. There is always a chance of unexpected gains. With higher risk also comes the prospect of future gains. The borrower will enjoy a benefit if interest rates decline, because the floating rate on his loan will go down. The lender will enjoy additional profit if interest rates rise, because he can then raise the floating rate charged to the borrower.
What are the disadvantages to floating interest?
The interest rate depends largely on market situations which can prove to be dynamic and unpredictable. Hence, the interest rate may increase to a point that the loan may become difficult to repay. The unpredictability of interest rate changes makes budgeting more difficult for the borrower. It also makes it harder for the lender to accurately forecast future cash flows. In times of unfavorable market conditions, large financial institutions might try to play it safe by putting the burden on customers. Therefore, they might charge high premiums over the benchmark rate, which could ultimately affect the pockets of borrowers.
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