What Is a Floating Interest Rate?

What Is a Floating Interest Rate?

Let me explain what a floating interest rate really means for you. It's an interest rate that doesn't stay put—it changes over time, moving up or down based on what's happening in the economy or financial markets. This rate floats in line with a specific index or benchmark, or just general market shifts.

You'll see these in things like credit cards and certain mortgage loans. They're also called adjustable or variable interest rates because they can vary throughout the term of your loan or credit.

Key Takeaways

Here's what you need to grasp right away: A floating interest rate moves with market conditions, unlike a fixed rate that never changes. You encounter them in credit cards and some mortgages. These rates mirror the market by tracking an index or another benchmark. And remember, floating rates— or variable ones—can heighten your financial risk as a borrower compared to fixed rates, since your monthly payments and interest costs might shift.

Understanding Floating Interest Rates

Many loans and debt products use floating interest rates, from credit cards to mortgages. As a borrower, you should know that this rate goes up or down with the broader market or a specific benchmark interest rate.

The benchmark or index varies by the loan type, but it's often something like the Secured Overnight Financing Rate (SOFR), the federal funds rate, or the prime rate—that's what banks charge their top corporate clients.

Banks add a spread over this benchmark for consumer products like personal loans, mortgages, car loans, or credit cards. This spread factors in things like the credit type or your credit score. So, you might hear a loan described as 'SOFR plus 300 basis points' or 'plus 3%.'

Keep in mind, these rates can adjust quarterly, semiannually, or annually.

Types of Floating-Rate Products

When it comes to home loans with floating rates, they're called adjustable-rate mortgages (ARMs). These adjust based on a fixed margin plus a mortgage index like SOFR, the Cost of Funds Index (COFI), or the Monthly Treasury Average (MTA).

For instance, if you have an ARM with a 2% margin over SOFR, and SOFR hits 3% at adjustment time, your rate becomes 5%—that's the margin plus the index.

Most credit cards use floating or variable rates on your unpaid balances. Your card agreement will say the APR is based on an index plus a margin, and it might note that 'this APR will vary with the market.'

Credit card rates usually tie to the prime rate, set by banks and influenced by the Federal Reserve's federal funds rate. The company adds a margin based on the card and your credit history.

Floating Interest Rate vs. Fixed Interest Rate

A floating interest rate is the opposite of a fixed one. With fixed rates, the interest stays the same for the whole loan term or part of it.

Mortgages can have either. Fixed means the rate locks in for the entire agreement—no changes. Floating means it can shift with the market.

If you get a fixed-rate mortgage at 4%, you pay that rate forever, with steady payments. But with a variable rate starting at 4%, it could go up or down, altering your monthly payments.

Example of a Floating Interest Rate Loan

Consider Herbert and Amanda buying a house with a $500,000, 30-year 7/1 ARM. Rates are low, so they start at 2%.

For the first seven years, it's fixed at 2%. Then it switches to floating, adjusting yearly based on SOFR.

In year eight, it rises to 4% with SOFR. Year nine, SOFR drops a bit, so their rate goes to 3.7%. Year ten, another drop to 3.5%.

Their payments fluctuate accordingly, and this continues until they pay off or refinance to fixed.

Advantages and Disadvantages of Floating Rates

On the plus side, floating-rate mortgages often start with lower rates than fixed ones, which can mean smaller initial payments and better approval chances. They're good if you plan to sell before adjustments or if you expect home values to rise fast. Rates might even drop, cutting your payments.

But the downsides are clear: Rates can climb, hiking your payments—maybe to unaffordable levels. It's hard to budget or predict long-term costs. You're basically at the market's mercy.

Advisor Insight

From James Di Virgilio, CIMA, CFP at Chacon Diaz & Di Virgilio in Gainesville, FL: For long-term borrowing, avoid floating or variable loans, especially when rates are low. You want to know your exact debt costs for accurate budgeting—no surprises.

Choosing variable means betting rates will fall. But in a low-rate environment, they're more likely to rise, increasing your interest. Fixed rates are smarter then.

Which Is Better, a Floating or Fixed Interest Rate?

It depends on your situation and rate outlook. Floating can save money if rates drop, but rising rates mean higher payments and tough budgeting—it's risky. Fixed gives stable payments and security when rates rise, but you miss out if rates fall.

What Is An Example of a Floating Rate?

A floating rate is a base tracking a benchmark like prime or SOFR, plus a margin. If tied to SOFR plus 6% and SOFR is 6%, your rate is 12%.

Do Credit Cards Have Floating Rates?

Yes, most do—variable rates tied to prime, plus a margin. If prime is 8% and they add 12%, you pay 20%.

The Bottom Line

A floating interest rate, or variable rate, changes with its benchmark. If the benchmark rises, so does your rate—and vice versa. You save if it drops, with lower payments, but pay more if it rises. That's the main risk with these products.