Definition
A floating-rate loan (or variable-rate loan) is a type of loan where the interest rate is not fixed over the life of the loan. Instead, the interest rate fluctuates, often in accordance with a specific short-term market indicator. In the UK, this market benchmark is typically the London Inter Bank Offered Rate (LIBOR). The rate can also follow other indices, such as the Federal Funds Rate in the United States.
Key Characteristics:
- Variable Interest Rate: The interest rate changes periodically, based on an underlying benchmark rate.
- Market-Linked: The interest rate is tied to a market indicator, which reflects current market conditions.
- Readjustments: Interest rates are usually readjusted periodically, say monthly, quarterly, or annually.
- Potential for Lower Interest Costs: Initially, these loans can have lower rates compared to fixed-rate loans.
- Risk of Rate Increases: Borrowers face the risk of increased monthly payments if market interest rates rise.
Examples
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Home Mortgage Loans: Many homebuyers opt for floating-rate (adjustable-rate) mortgages, typically offering lower initial interest rates that adjust based on market conditions after an introductory period.
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Student Loans: Some student loan programs provide floating-rate options, which may have lower rates initially but fluctuate with market conditions.
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Business Loans: Businesses often use floating-rate loans for working capital or financing variable expenses, benefiting from potentially lower borrowing costs during periods of falling interest rates.
Frequently Asked Questions (FAQs)
What determines the interest rate of a floating-rate loan?
The interest rate of a floating-rate loan is typically linked to a benchmark rate, such as LIBOR, Federal Funds Rate, or Prime Rate. The loan agreement will specify the index and frequency of rate adjustments.
Are floating-rate loans riskier than fixed-rate loans?
Yes, floating-rate loans can be riskier due to the uncertainty of future interest rate movements. Borrowers face potential increases in their monthly payments if market rates rise.
Can a floating-rate loan ever convert to a fixed-rate loan?
Some floating-rate loans come with conversion options that allow borrowers to switch to a fixed rate at certain periods, often after the initial adjustable period.
Why would someone choose a floating-rate loan?
Borrowers might choose floating-rate loans for the potential for lower initial interest rates and lower initial monthly payments, particularly if they anticipate stable or falling interest rates.
How often do rates adjust on floating-rate loans?
Rates on floating-rate loans adjust periodically - typically monthly, quarterly, or annually, based on the terms of the loan.
Related Terms
- Fixed-Rate Loan: A loan with an interest rate that remains constant throughout the life of the loan.
- LIBOR (London Inter Bank Offered Rate): A benchmark interest rate at which major global banks lend to one another.
- Prime Rate: The interest rate that commercial banks charge their most creditworthy customers.
- Adjustable-Rate Mortgage (ARM): A type of mortgage with an interest rate that is periodically adjusted based on an index.
- Interest Rate Cap: A limit on how much the interest rate on a variable-rate loan can increase during any single adjustment period or over the life of the loan.
Online References
- Investopedia: Floating Rate Loan
- U.S. Securities and Exchange Commission: Floating Rate Notes
- The Balance: Floating-Rate Loans
Suggested Books for Further Studies
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen - This book provides an in-depth look at how corporations handle debts, including floating-rate loans.
- “Fixed Income Securities” by Frank J. Fabozzi - Offers detailed insights into various securities including floating-rate loans.
- “The Handbook of Fixed Income Securities” by Frank J. Fabozzi - An extensive resource covering various aspects of fixed and floating income investments.
- “Interest Rate Markets: A Practical Approach to Fixed Income” by Siddhartha Jha - Discusses the dynamics of interest rate markets including variable-rate loans.
Accounting Basics: “Floating-Rate Loan” Fundamentals Quiz
Thank you for joining us on this comprehensive exploration of floating-rate loans. Remember, staying informed helps you make wise financial decisions.
