Last editedOct 20212 min read
Interest rates essentially refer to the amount of money that you are charged for borrowing, represented as a percentage total of the loan. Understanding interest rates is important when borrowing money of any kind, whether it’s for a mortgage or a business loan.
A floating interest rate is best understood by looking at the difference between floating and fixed interest rates. In a nutshell, a floating interest rate is one that can move up or down with the market or an index, and therefore is also known as a variable interest rate. On the other hand, a fixed interest rate stays constant throughout the term of a loan.
Find out more about fixed and floating interest rates and their importance to your business financing by reading this short guide.
Understanding fixed and floating interest rates
Floating interest rates can fluctuate, but what exactly influences this? Usually the interest rate is based on a reference, sometimes called a ‘benchmark’, that is independent to either party involved in the contract. This interest rate is typically a recognized benchmark such as the prime rate, i.e., the lowest rate that commercial banks charge for a loan.
A change in market rates can therefore affect the current floating interest rate. This can be beneficial for the borrower if the market rate falls, but conversely can result in an increased interest rate if the market rate rises. For this reason, floating interest rates involve a higher level of risk than fixed interest rates.
Advantages of floating interest rates
The most obvious advantage of a floating interest rate is that it can decrease, resulting in lower interest payments for the borrower. This can mean great savings for business loan interest rates and reduced monthly spending on mortgages. However, this is risky, and there is no guarantee that the current floating interest rate won’t increase.
In addition to this, you should also remember that floating interest rates tend to have a lower introductory value than fixed rates. This is therefore beneficial if you are able to repay your loan quickly before the rate adjusts.
Disadvantages of floating interest rates
The main difference between floating and fixed interest rates is that a floating rate is much more unpredictable. This is also a key disadvantage, making it difficult for borrowers to plan their budget and sometimes leaving them unable to make repayments. As a knock-on effect, this can lead to a longer loan term and greater repayments, and therefore involve larger financial risk.
Is a floating rate of interest in a home loan a good idea?
It can be difficult to decide on fixed and floating interest rates for a home loan, and there’s no definitive answer on which is best. When it comes to shorter term loans, it’s usually best to go for a floating rate as you will be offered a better starting rate and interest is unlikely to change significantly in a short period. If you think that you will be paying the loan for a longer period, then it’s better to go with a fixed rate as significant increases in interest could occur over the term of your loan.
Is it possible to do a floating to fixed interest rate swap?
Some borrowers find that interest rates are increasing and want to make a floating to fixed interest rate swap, or vice versa. This kind of arrangement is possible, but requires both the borrower and the lender to mutually agree. For example, the party being paid may want a more guaranteed rate for their repayments, and the borrower may believe that interest rates may rise and wants to avoid higher repayments.
An interest rate swap is a derivative contract. This means that the lender and borrower make an additional contract agreeing to pay each other the difference in loan payments specified in the original contract. There is no exchange of debt assets, and borrowers must simply pay the difference in interest payment as a result of the swap contract.
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