What Is a Floating Rate Loan?

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Written by: Josh McFadden | Best Company Editorial Team

Last Updated: December 4th, 2019

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Certainly, one of the first things a person asks when considering a loan is what the interest rate is. These rates, of course, fluctuate and vary depending on the type of loan (for example, mortgage loan rates are much lower than credit card rates). Still, this percentage is critical in the loan approval and payback process.

Fixed rates vs. floating rates

Generally, there are two types of interest rates: fixed and floating, or sometimes called variable or adjustable. A fixed rate is self-explanatory: It stays the same throughout the life of the loan, whether that term is two years or 30 years. In a fixed rate, the interest rate will never change, unless there is a refinance on the loan.

Floating rates are quite different. In these types of rates, the loan or credit will start off with a given interest rate, and then that rate will change during the loan's existence. Depending on certain factors, that rate might go up in one instance and then drop down at another.

What loans allow floating rates?

Most types of loans have the option of using a floating interest rate. On of the most popular are mortgage loans, where the term is usually identified by the name adjustable rate mortgage, or ARM.

Personal loans may also use floating rates, as can business loans. In either case, the rates will increase or decrease according to market conditions and as interest rates in the wider market change.

Why you'd want a floating rate

One of the most appealing features of a floating rate is that the borrower has the flexibility to make lump-sum payments whenever desired without worrying about prepayment penalties.

Another plus to floating rates is that when the market is good-when conditions are favorable-the borrower can be the benefactor of some handsomely good rates. This will allow the borrower to pay off the loan even faster, since monthly payments will naturally decrease.

Why you wouldn't want a floating rate

On the other hand, a borrower with a floating rate loan is at the mercy of the financial market. If things take a negative turn, your rate could easily rise well above the going fixed rate. This means higher monthly payments and a potential burden for fixed-income families living on a tight budget.

It is impossible to predict where floating rates will go. If your finances are not as stable as you would like, or if your career is in a tenuous position, a floating rate could be a dangerous prospect for a borrower.

The final word

Whether to select a fixed or floating rate is largely a personal choice. Make sure you evaluate your own financial situation. Also, if you know you will be in your home for a short time, a floating rate is much less risky than if you plan to be there long term.

A fixed rate is generally a safer bet, but a floating rate has the potential to save you more in the long run. Unfortunately, a floating rate can also cause you to pay more and to pay longer.

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