Floating Interest Rate

Whenever you took out a loan, you must have wondered why your monthly loan payment amount differed. This could be explained by a simple concept: floating interest rates. Interest rates have a significant impact on your loan EMIs. They go up or down with the changes in the overall economy.

The higher the interest rates, the higher the cost of your loan, which you want to avoid. So, a fixed interest rate may seem to be a good option. However, you cannot benefit from lower interest rates with that. In this article, we help you understand floating interest rates and their calculation so that you can make smart financial decisions.

What is a Floating Interest Rate?

A floating rate is a variable rate that changes throughout its lifetime to meet prevailing market conditions. It is also known as the variable interest rate. Loans at floating rates are subject to periodic adjustments in line with the changes in the general interest rates in the market.

It changes in response to a reference or benchmark rate beyond the control of the parties to the contract. The reference rate is usually a recognised benchmark rate, such as the prime rate, the lowest rate commercial banks charge their most creditworthy customers, typically large corporations or high-net-worth individuals.

Floating-rate debt can sometimes be cheaper than fixed-rate loans, depending on the shape of the yield curve. In return for having a lower upfront cost, the borrower accepts more interest rate risk - the risk of rates rising in the future. If the yield curve becomes inverted, floating interest-rate loans may become more expensive than fixed-rate debt; however, an inverted yield curve is relatively rare.

Floating rates are usually cheaper for longer terms, such as a 30-year mortgage. Lenders charge fixed rates for longer terms at a higher rate due to the uncertainty of correctly projecting the economic conditions over that extended period and on the expectation of increased interest rates over time.

Some floating rates also incorporate additional features, such as caps on the maximum interest rate or limits on how much the rate can increase between adjustment periods. These features are standard in many mortgage loans to prevent borrowers from facing an unexpected, prohibitively expensive rate increase that they cannot afford to repay.

Uses of Floating Interest Rate

Floating interest rates have several applications, commonly found in:

• Mortgage Loans: Floating interest rates are widely used in mortgage loans, where the rate is determined based on a reference rate or index, such as “prime rate plus 1%.”
• Credit Cards: Some credit card issuers offer floating interest rates, often calculated as the prime rate plus an additional percentage.
• Corporate Loans: Banks frequently provide floating rate loans to large corporations, where the interest rate is the base rate plus or minus a margin or spread.

Mechanism of Floating Rate

Benchmark rate normally means the reference interest rate used in determining various interest rates on different financial instruments, including floating-rate bonds. A benchmark generally refers to a standard against which other interest rates are measured.

Benchmark rates are set by the central banks of a country through their monetary policy decisions. Benchmarks are related to and influenced by general market factors, such as inflation, economic growth, and investor sentiment.

Examples of benchmark rates commonly used in India are:

• MIBOR ( Mumbai Interbank Offered Rate) - Reference rate for short-term loans amongst banks in India.
• Repo Rate - The rate at which banks and disbursing authorities borrow money from the Reserve Bank of India.
• G-Sec Index - It represents the yield from different government securities in India.
• MCLR (Marginal Cost of Funds-based Lending Rate) - This is another criterion for the banks to quote a minimum interest rate below which they cannot lend.
• T-Bill Rates - The return on Treasury Bills issued by the Government of India, usually used as a yardstick for some types of loans and bonds.

The spread refers to the additional percentage points added to the benchmark rate to arrive at the final interest rate that borrowers are charged. This spread compensates lenders for a risk premium and administrative costs associated with lending.

For example, when the benchmark rate, such as MIBOR, is 6% with a spread of 2%, the effective floating interest rate for the borrower stands at 8% per annum.

It indicates the margin over the cost of the funds represented by the benchmark rate that financial institutions ensure as a profit. It also reflects the judgment of the lender on the credit risk of the borrower.

What is Floating Interest Rate Calculation?

The formula for calculating the interest expense on securities priced on a variable basis is as follows:

Floating Interest Rate (%) = Base Rate + Spread

The base rate is aligned based on the benchmarks such as MCLR or RBI repo rate. Generally, floating rates are connected with senior debt instruments, while fixed rates are typical with bonds and other less secure debts. This is crucial for people investing in debt instruments.

Various factors influence the floating interest rate. Inflation, monetary policy, and changes in the base rate proper are some of them. Because floating rates are varying, this calculation can be imprecise sometimes. Therefore, it is reasonable to use an investment EMI or a lending EMI calculator to avoid misperception.

Comparison: Floating Interest Rate Vs Fixed Interest Rate

The fixed interest rate refers to the constant rate used on an obligation, like a loan or mortgage, which does not vary over a certain period of time. The rate charged may be fixed for the whole or a part of the loan term. In most cases, various lenders offer different interest rates, including hybrids combining a fixed rate for some terms and an adjustable one for the rest.

Below is a quick comparison of floating and fixed interest rates:

Floating or Fixed Interest Rate – Which is Better?

Choosing the correct interest rate is crucial to your financial well-being. It's essential to compare different options and understand all the details before deciding. If stability and predictability are your main priorities, a fixed interest rate might be the best choice, though it usually comes with higher costs.

Individuals should consider a floating rate in the following situations:

• Borrowers often choose a floating-rate loan when they expect interest rates to decrease or remain flexible during the loan term. This interest type also allows for easier prepayments, enabling borrowers to pay off their debt faster with a lower interest burden.
  
• Investors may opt for floating rate instruments when they believe the base rate will remain stable or change in their favour. In such cases, the interest earned on investments remains consistent or increases. However, it's crucial to evaluate the benefits of a variable interest rate to determine whether it will help save or earn more over time.

Floating Rate Market Instruments

The following market instruments are influenced by the floating interest rates:

Floating Rate Bonds

Floating Rate Bonds (FRBs) rate of interest is allowed to reset from time to time with respect to a benchmark, that could be MIBOR or Repo Rate. The primary issuers in India include the Government of India. Currently, the rate for RBI Floating Rate Savings Bonds 2020 is fixed at 8.05% over a seven-year term. In the same period, corporate issuers like Tata Capital also have FRBs linked to MCLR to provide flexible income opportunities.

Floating Rate Savings Bonds

Government-issued Floating Rate Savings Bonds (FRSBs) are variable-rate debts tied to a benchmark, such as the NSC rate, reset semi-annually. RBI has recently announced 8% interest rates on its FSRB 2034, which will mature in 2034. The floating interest will be revised every six months based on the T-bills benchmark rate. Typically, the rates for FRSBs vary with market conditions.

Floating Rate Loans

Floating rate loans in India, like home loans from HDFC Bank, are linked to the Repo Rate. The rates are reset once every six months. For example, the Repo Rate in 2024 is 6.5%. This will have an implication for the loan EMIs. A few corporate loans, like those of Reliance Industries, are usually linked to MIBOR but allow quarterly adjustments.

Floating Rate Mutual Funds

Floating-rate mutual funds invest in debt securities with floating interest rates to outperform the rise in rates. For instance, the SBI floating rate debt fund's trailing returns for 1 year is 8.21%. They are not as volatile as other fixed-rate alternatives and return a steady income linked to the current market conditions.

Fixed Deposits at Floating Rates

The interest rates of floating rate FDs are changed from time to time in accordance with a benchmark rate, usually the Repo Rate or MIBOR. This type of deposit is utilised to hedge against rising interest rates. For instance, the floating-rate FD offered by ICICI Bank has a quarterly resetting interest rate based on market conditions. Deposits of this nature enjoy a better interest rate, thus improving returns over and above regular fixed deposits.

Conclusion

On the one hand, floating interest rates can offer flexibility and potential savings. If interest rates decline, your loan payments will also decrease. Conversely, your savings accounts may earn higher interest if interest rates rise. On the other hand, floating interest rates can introduce uncertainty and potential risks.

If interest rates rise significantly, your loan payments could increase, making it more challenging to manage your finances. However, a fixed interest rate might be a better choice if you prefer stability and predictability. The best approach to floating interest rates is carefully considering your circumstances and risk tolerance.

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