Difference between Floating, Variable and Adjustable Interest Rate
Regardless of whether you call it a floating interest rate, a variable interest rate, or an adjustable interest rate, the end result is the same: an interest rate that is adjusted according to the prevailing market conditions. Given this type of arrangement, the interest rates will vary throughout the duration of the loan terms, which is one of the key characteristics of these types of loans.
How Rates Are Determined
Floating interest rates are typically based on an index or benchmark rate. The index used to determine the specific interest rate is generally included in the terms of the loan. In most cases, lenders will also charge a spread, or added percentage points on top of the established index rate. If a loan is billed as “prime plus 2.5%,” which means that for a prime rate of 3.5%, the terms of the loan will require the borrower to pay off a 6% interest. Some loans may even impose a negative rate spread.
Advantages/Disadvantages
A floating interest rate seems like a feasible idea for many people, since it has the distinct advantage of allowing borrowers to enjoy lower costs when interest rates go down. This means that borrower will have to pay lower service costs on the loan during the times when interest rates are low. This may prove disadvantageous later on however, particularly when the interest rates do increase, since this will mean that borrowers will have to pay higher rates. With a fixed interest rate on the other hand, borrowers can expect a steady interest rate for the duration of the loan terms.
In times when the interest rates are high, borrowers would be better off going for a loan with a floating interest rate. When the interest rates do go down, as they inevitably will, the borrower may have the option to refinance or fix the loan at a lower rate. Information on how to take advantage of this alternative is typically provided when you apply for the loan. If the interest rates are low on the other hand, you would be better off going for a fixed rate loan.
Reset Dates
Floating interest rates typically involve periodic reset dates for the loan, particularly when the index rate changes. Resets may also occur online at market predetermined intervals, with yearly adjustments being a common arrangement. Again this information is typically provided in the loan paperwork, so you will be able to determine when any changes are scheduled. Keep in mind however, that interest rate resets may also entail an adjustment of your monthly payments in order to keep you in compliance with the terms of the loan agreement.
Summary
- Are typically based on an index or benchmark rate
- The index used to determine the specific interest rate is generally included in the terms of the loan
- Lenders may also charge a spread or added percentage points on top of the established index rate
