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.

Floating interest rates typically change based on a reference rate (a benchmark of any financial factor, such as the Consumer Price Index). 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).

The rate for such debt will usually be referred to as a spread or 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. 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.

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