Floating Interest Rate: Meaning, Benefits, Pros, Cons, Calculation

A floating interest rate, also known as a variable interest rate, is an interest rate that changes over time. Floating interest rates are common in student loans, home loans, and credit card agreements. Students may benefit from floating interest rates when borrowing for education during periods of economic stability. Unlike fixed rates, floating interest rates fluctuate based on market conditions.

Floating rates can be attractive to students who are confident in their ability to manage loan fluctuations and anticipate that market conditions will remain stable or favorable. One of the biggest advantages of a floating rate is that it often starts lower than a fixed rate. Let us read more about floating interest rate in detail along with factors that affect it and its advantages for students looking for education loans.

What is Floating Interest Rate?

The Floating rate of interest is the rate of interest that keeps on fluctuating as per the variations in the benchmark. These benchmarks include the Prime Rate or the LIBOR (London Interbank Offered Rate). Floating interest rates are often used for loans like mortgages, student loans, and credit cards. The rate may be adjusted periodically—every month, quarter, or year—depending on the terms of the loan agreement.

The floating interest rate can fluctuate during the term of a loan or credit, making it different from a fixed interest rate, which remains constant throughout. For example, if a student takes out a loan with a floating interest rate, their monthly payments may change periodically as the rate adjusts. Typically, these rates are expressed as a certain percentage above or below the benchmark rate.

LIBOR in Floating Interest Rates

The LIBOR (London Interbank Offered Rate) is one of the most widely used benchmarks for floating interest rates. It represents the interest rate at which major international banks lend to each other. LIBOR is used to set rates for many types of loans, including student loans and mortgages.

LIBOR is usually set for different periods, such as overnight, one-month, or one-year, and fluctuates based on market conditions. When LIBOR rises, loans linked to it will also see an increase in interest rates, making repayments higher. Students should understand that any loans they take out that are tied to LIBOR will be affected by changes in this rate, which can impact the total interest they pay.

How Does a Floating Interest Rate Work?

A floating interest rate works by adjusting based on a specific benchmark rate that reflects the market’s general economic conditions. This floating interest rate is typically reviewed and adjusted periodically (e.g., every month, quarter, or year). For instance, a common formula used is:

Floating Rate = Benchmark Rate + Spread (fixed margin)

The “spread” is the extra amount added to the benchmark rate and is agreed upon at the time of borrowing. If the benchmark rate increases, the floating rate will increase, leading to higher interest charges on the loan. Similarly, if the benchmark rate decreases, the floating rate will decrease, reducing the interest charges. For students, understanding how these rates adjust is essential, as it can significantly impact their repayments.

Advantages of Floating Interest Rate

A key risk of floating interest rates is their unpredictability, making budgeting challenging. But there are various advantages to choosing a floating rate of interest over a student loan. Some of them are as follows:

• The floating rate of interest on student loans starts from very low interest rates.
• The rate of interest is usually more affordable during the first year of interest payment.
• There are chances to reduce the amount of interest, only if the inflation rate is not high.
• Floating interest rates remain lower than fixed rates for extended periods, especially during favourable economic conditions.
• There are more chances of substantial savings over the tenure of the loan, especially during a long repayment term.
• The dip in the interest rates decreases the monthly payment as well.

Also Read: Inflation And Its Effects On Education Loans: A Detailed Guide 

Disadvantages of Floating Interest Rate

Borrowers with education loans linked to floating interest rates must prepare for potential increases in monthly payments. The floating rate of interest has some disadvantages which are as follows:

• Due to fluctuations in interest rates, the monthly interest rate payment is unpredictable.
• The total amount of interest may vary as the market rate fluctuates.
•  The uncertainty of the interest rate payment creates challenges.
• The uncertainty can create stress and anxiety for borrowers.
• There are chances of paying more interest in comparison with fixed interest rate loans.
• Sometimes, overpayment of interest amount may increase the financial burdensome
• Sometimes overpayment may lead to difficulties in managing loan payments.

Floating vs. Fixed Interest Rates

Interest rates can be categorized into two types. One is the Fixed rate of interest and the other is the floating rate of interest. A floating interest rate changes over time based on market conditions, offering the potential for lower payments when rates decrease but risking higher costs if rates rise. In contrast, a fixed interest rate remains constant throughout the loan term, providing predictability and stability in repayment amounts, which is ideal for borrowers who prefer certainty in their budgets.

Let us see more differences between floating interest rates and fixed interest rates:

Feature	Floating Interest Rate	Fixed Interest Rate
Rate Stability	Changes with market conditions	Remains constant throughout the loan term
Monthly Payment	Varies based on interest rate changes	Fixed and predictable
Initial Interest Rate	Typically lower than fixed rates initially	Usually higher than floating rates initially
Risk	Higher risk due to potential rate increases	Lower risk as payments are unaffected by rate changes
Suitability	Ideal for short-term loans or when rates are expected to decrease	Best for long-term loans or risk-averse borrowers

Also Read: A Comprehensive Guide To Apply For An Education Loan In Australia 

Factors That Influence Floating Interest Rates

Several factors play a significant role in influencing floating interest rates, which can be impacted by both domestic and global economic conditions. Understanding these influencing factors can help students predict how floating rates might change over time, especially if they have variable-rate loans:

• Central Bank Policies: Central banks, such as the Federal Reserve in the U.S., regulate the money supply and set interest rates to influence economic activity. When central banks raise or lower their rates, floating rates often follow suit.
• Inflation: Rising inflation often leads to higher interest rates, as central banks might increase rates to curb inflation. This, in turn, drives up floating rates.
• Economic Growth: In periods of strong economic growth, the demand for credit increases, leading to higher interest rates. Conversely, during economic slowdowns, interest rates may decrease to stimulate borrowing.
• Global Market Trends: International events, such as geopolitical instability or financial crises, can cause interest rates to fluctuate. Students must stay informed about global trends that could impact their loans.

How Floating Interest Rates Affect Loan Repayments?

Floating interest rates have a direct effect on loan repayments because they can change periodically. As the interest rate rises or falls, the amount of interest charged on the principal also changes. For example, a student loan with a floating rate might start at 4%, but if interest rates increase due to market conditions, it could rise to 5%, raising the monthly payment. Students should be prepared for such adjustments and ensure they have enough income to manage higher payments if necessary.

Hence we can summarise the impact of floating interest rates in loan repayments as:

• Higher Interest Payments: If the benchmark rate increases, your monthly payment will rise because the interest rate on your loan will increase.
• Lower Interest Payments: If the benchmark rate decreases, your monthly payment will decrease as well, helping you save money in the long run.

When Should You Consider a Floating Interest Rate?

Students should carefully consider whether they can handle fluctuations in their loan repayment amounts and whether they believe interest rates will stay low or rise. A floating interest rate can be a good option in the following situations:

• Stable or Decreasing Interest Rates: If the economy is stable, or there’s a low chance of rates increasing, a floating interest rate can help you save money by taking advantage of lower rates.
• Short-Term Loans: If you plan to pay off the loan quickly, the short-term lower rates can make floating interest rates attractive. A student who plans to finish their loan in a few years might benefit from a lower rate in the early stages.
• Financial Flexibility: If you have a flexible financial situation and can handle potential rate increases, a floating rate might suit you, as it offers the possibility of reduced payments if the market conditions improve.

Floating Interest Rates in Home Loans

For students considering a future home loan, floating interest rates can be appealing due to their potential for lower initial payments. Understanding these factors can help students make better-informed decisions when taking out home loans. However, it’s important to carefully evaluate the following things:

• Rate Adjustment Frequency: How often the rate is adjusted. More frequent adjustments may lead to more unpredictable payments.
• Ceilings: Some floating-rate loans have a cap or ceiling, which prevents the interest rate from exceeding a certain level, providing some level of protection against extreme rate increases.

FAQs

The floating rate of interest offers lower interest rates initially but the rate of interest may fluctuate and can increase or decrease the overall rate of interest and loan cost. So, the choice between a floating rate or a fixed rate of interest should depend on the financial plan and stabilities. No matter which type of interest rate you choose, responsible financial planning is the key to the successful repayment of student loans.