Floating Interest Rates: A Complete Guide
Are you moving to a new area for only a short period of time? Or maybe you’re comfortable with a fluctuating budget. Depending on your financial situation, a loan with a floating interest rate may be right for you. But before you take the leap, it's essential to understand their perks and the possible downsides. Follow along below to see how floating interest rates work and explore whether they’re the correct choice for you.
What Is A Floating Interest Rate?
A floating interest rate means that your rate of interest will fluctuate over the life of your loan depending on economic and market conditions. A floating interest rate on a mortgage loan, also known as an adjustable-rate mortgage (ARM), typically begins with a period of 1 – 10 years with a fixed interest rate, during which you’ll pay the same amount every month for your mortgage. Once this initial period is over, your floating rate mortgage will "float" up or down, increasing or decreasing your mortgage payments.
Floating Interest Rate Vs. Fixed Interest Rate
The key difference between floating interest rates and fixed interest rates is that a floating rate will fluctuate over time, while a fixed rate will remain the same throughout the life of the loan. However, there are some other significant differences that you should understand. One factor that makes floating interest rates so enticing is that they generally have lower initial rates than fixed rates. During the initial period that your floating interest rate is fixed, you could save a considerable amount of money every month compared to a fixed-rate loan. That's why floating interest rates are popular among home buyers who plan to take advantage of the lower rates and sell their home before their initial period ends. However, you should keep in mind that if interest rates go up after your initial period, you could pay considerably more compared to fixed interest rate loans.
How Does A Floating Rate Work?
Once your initial period with fixed interest payments ends, you enter the adjustment period. This is when your floating rate can begin changing. How much your rate changes, how often it changes and how high or low it can change depends on many factors. These include the terms of your loan, market conditions outside of your control and your personal financial situation. Your floating interest rate is calculated in two parts: your index and margin rates.
Your index rate is based on general economic indicators of interest rates in the market. It changes based on financial conditions and causes fluctuations in your floating rate mortgage. Lenders can use different indexes as the benchmark to determine the index rate, so knowing what index your lender uses is essential. Some of the most common indexes are:
- 1-year constant maturity Treasury (CMT) Index: a measurement of the value of U.S. Treasury securities and one of the most widely used indexes for floating mortgage rates.
- The federal funds rate: the target range of interest rates that banks use to borrow money from each other overnight to adjust their liquidity. When the federal funds rate increases, interest rates on the loans they provide also increase, including floating rate loans.
- London Interbank Offered Rate (LIBOR): an interest rate that global financial institutions use to loan money to each other. LIBOR was formerly a major index that lenders based floating rates, but a lending scandal is causing it to be phased out.
- The prime rate: the best interest rate a borrower could possibly get from a lender. It can be influenced by all of the factors above.
Your margin rate is the additional percentage points you pay on top of your index rate. The lender sets the margin rate based on your financial situation, such as your credit score, and does not change it throughout the life of the loan. To calculate the rate you pay each month, add your index rate to your margin rate to get your fully indexed rate.
Floating Rate Mortgage Example
Let's say you‘re entering your adjustment period on a $300,000 mortgage with a floating interest rate. Instead of the fixed interest rate you've been paying for the last year, you’ll start paying based on your floating rate. One of the most critical factors to consider is what index the lender uses to determine your index rate. If they use the 1-year CMT index, your index rate would be 4.7% as of May 10, 2023. Your margin rate, determined when you received the loan, is 2%. To calculate your monthly payment, simply add 4.7% and 2% to get 6.7%. At this rate, you would pay $1,675 per month in interest.
Your mortgage rate will be 6.7% for a period set by the terms of your loan. Your loan terms will also set the next time your index rate will change. Most floating rate mortgages adjust every 6 months or every year, but some may adjust as much as every month or as little as every 5 years. Your loan terms will also include caps on how much your index payment can change with each adjustment and throughout the loan's lifetime.
If your rate adjusts annually, you will want to monitor the CMT index leading up to your adjustment date every year. Let's say the 1-year CMT rate a year from now is 5.2%. Your margin rate of 2% will not change, so your new monthly rate will go to 7.2% and $1,800 monthly interest payments.
The Pros And Cons Of Using A Floating Rate Mortgage Loan
There are both advantages and disadvantages to floating rate mortgages, including:
- Lower initial interest rate
- Smaller monthly payments, at least for some time
- Potential for interest rates to float down if market rates drop
- Decreased likelihood of facing a prepayment penalty
- Can save money if you plan on selling in a short time
- Less predictable monthly payments
- Difficulty planning finances
- Potential for the interest rate to increase if the market rate climbs
- Complicated payment terms
What Home Loans Do Floating Interest Rates Apply To?
Conventional loans are not your only option to secure a floating interest rate. You can receive an FHA loan with a floating rate with an initial fixed-rate period lasting 1, 3, 5, 7 or even 10 years. You can also qualify for a floating interest rate for a VA loan, but floating rates are unavailable for USDA loans.
The Bottom Line
Floating interest rates change depending on economic conditions. Mortgage loans with floating interest rates typically have an initial period when you pay a fixed interest rate, followed by an adjustment period in which you pay a variable rate. The rate is based on an economic index and an additional margin added by the lender.
Floating interest rate mortgages can be an excellent choice if you want to take advantage of lower rates for a short period before the rates become unpredictable, but it’s important you understand how they work as they can be complicated loans. When you're ready to get started on your home buying journey, speak with a lender about the terms of their floating interest rate loans to see if they're suitable for your financial situation.