In business and finance, floating interest rates, a floating rate, variable rate or adjustable rate refers to any type of loan, bond, mortgage or credit that does not have a fixed rate of interest over the life of the loan. A loan is a type of Debt. This article focuses exclusively on monetary loans although in practice any material object might be lent In Finance, a bond is a Debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and Interest A mortgage is the pledging of a property to a Lender as a security for a Mortgage loan. A fixed interest rate loan is a Loan where the Interest rate doesn't fluctuate during the fixed rate period of the loan Such loans typically use an index or other base rate for establishing the interest rate for each relevant period. A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract One of the most common rates to use as the basis for applying interest rates is the London Inter-bank Offered Rate, or LIBOR (the rates at which large banks lend to each other). The London Interbank Offered Rate (or LIBOR, ˈlaɪbɔr is a daily Reference rate based on the Interest rates at which Banks offer to lend
The rate for such loans will usually be referred to as a spread or margin over the base rate: for example, a five-year loan may be priced at six-month LIBOR + 2. 50%. At the end of each six-month period, the rate for the following period will be based on 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.
Banks may prefer to lend to their customers with floating rates, since they are raising funds (through deposits, bond issues, and by borrowing from other banks or the money market). A deposit account is a current account at a Banking institution that allows money to be deposited and withdrawn by the account holder with the transactions and resulting balance In Finance, the money market is the global Financial market for short-term borrowing and lending Pricing loans to their customers in the same currency and basis allows banks to manage the balance between their assets and liabilities. In Business and Accounting, assets are everything owned by a person or company (all tangible and intangible property that can be converted into cash.
Typically, floating rate loans will cost less than fixed rate loans, depending in part on the yield curve. In Finance, the yield curve is the relation between the Interest rate (or cost of borrowing and the time to maturity of the debt for a given borrower In return for paying a lower loan rate, the borrower takes the interest rate risk: the risk that rates will go up in future. Interest rate risk is the risk (variability in value borne by an interest-bearing asset such as a loan or a bond, due to variability of interest rates. In cases where the yield curve is inverted yield curve, 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). Interest rate risk is the risk (variability in value borne by an interest-bearing asset such as a loan or a bond, due to variability of interest rates.
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. Interest rate cap An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed
Example
A customer borrows $100,000 from a bank; the terms of the loan are (six-month) LIBOR + 3. 5%. At the time of issuing the loan, the LIBOR rate is 2. 5%. For the first six months, the borrower pays the bank 6% annual interest: in this simplified case, $3,000. At the end of the first six months, the LIBOR rate has risen to 4%; the client will pay 7. 5% (or $3,750) for the second half of the year. At the beginning of the second year, the LIBOR rate has now fallen to 1. 5%, and the borrowing costs are $2,500 for the following six months.
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