A floating interest rate is an adjustable interest on a debt instrument such as a loan or mortgage. The interest rate changes depending on a market rate outside of your lender’s control. Typically, the interest rate is reassessed or changed very 1, 3, 6, or 12 months, depending on the period that was agreed upon between the lender and borrower. A commonly-used market rate is the London Inter-bank Offered Rate.
For example, if you obtained a 2% floating interest rate where the loan is reassessed every 3 months in January, then your interest may be at 5% in April and at 1% in July.
On the other hand, a fixed rate loan is where the interest stays the same throughout the life of your debt instrument.
For example, if you obtained a 5-year car loan for an interest rate of 2.99%, your interest rate when remain fixed at 2.99% throughout those 5 years and will not change.
Depending on when you obtained your interest rate, a floating interest rate may be the better deal. However, with floating interest rates, you bear the risk of the interest rate increasing in the future. But some debts, such as mortgages, have interest rate caps, where there is a limit on the maximum interest rate or the maximum change allowed.
For example, you obtained a mortgage with a 5% floating interest rate and a 2% maximum interest rate cap. You will never have to pay anything over a 7% interest rate even if the current market rate is 8%. However, you must pay at least 3% interest rate even if the current rate is lowered to 1%.
A floating interest rate may increase to the point where a borrower can no longer repay the loan. When such happens, the borrower may request a loan modification. A loan modification can:
- Change from a floating interest rate to a fixed interest rate
- Reduce the late fees
- Reduce the principal payments
- Lengthen the loan term
- Set a maximum monthly mortgage payment
- Prevent foreclosure
An attorney experienced in loans and mortgages can help you understand and utilize floating interest rates. You may wish to contact a real estate attorney for advice.