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A Quick Intro To The Floating Interest Rate

May 21, 2024 6-minute read

Author: Dan Rafter

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When you apply for a mortgage, you can choose from a wide variety of loan options. You can opt for a shorter-term mortgage, one you can pay off in 10 or 15 years, or a longer-term loan that can take 30 years to pay off. Another home loan option you’ll need to decide is whether the mortgage will have a fixed or floating interest rate.

What Is A Floating Interest Rate?

A floating interest rate changes periodically throughout the life of your loan. Depending on the economy and market conditions, your mortgage interest rate will either “float” up or down. In most cases, a floating rate is linked to a specific index or another benchmark.

In the mortgage industry, loans with floating rates are called adjustable-rate mortgages (ARMs). For other consumer products with floating rates, such as credit cards or personal lines of credit, the term “variable interest rate” is more common.

Mortgages with floating interest rates usually start with a fixed introductory period. The rate stays the same during this period, typically 5 – 10 years. For example, suppose you take out a 30-year mortgage with a floating interest rate. Your lender may offer a fixed rate for the first 5 years of the loan’s term. After 5 years, the rate will adjust annually. This means your rate could change for the remaining 25 years or until you pay off the loan.

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How Do Floating Interest Rates Work?

Floating interest rates are typically tied to an economic index.

Your loan’s floating interest rate may be tied to the prime rate, the baseline rate consumers with good credit can qualify for. If the prime rate increases, your loan’s interest rate will likely climb. Other indexes, such as the federal funds rate, are also used by financial institutions. The prime rate may actually change based on the federal funds rate. It’s typically 3% higher than the federal funds rate.

Which index your lender uses will depend on the type of loan you apply for and your location.

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Fixed Vs. Floating Interest Rates

Should you go for a fixed-rate or adjustable-rate loan when you apply for a mortgage? What you ultimately decide will depend on your goals. Before we dive deeper into fixed and floating (adjustable) rates, you can scan through a quick overview of their key differences:

 

Floating Rate

Fixed Rate

How They Work

Rate fluctuates after fixed period ends

Rate stays the same over the life of the loan

Benefits

Lower introductory interest rate and monthly payments

Consistent monthly mortgage payments

Drawbacks

Harder to budget after introductory period

Higher interest rates

When To Use

Anticipate refinancing or selling the home before introductory period ends

Plan to stay in the home and want consistent payments over the loan’s term

Floating Interest Rates And Your Mortgage

The benefit of an adjustable-rate mortgage is that you’ll save money on your loan upfront. Adjustable-rate mortgages typically offer lower interest rates during their introductory periods than what you’d get with a fixed-rate loan.

The potential challenges start after an ARM’s fixed period ends. That’s when the floating interest rate can change, rising or falling once or twice a year, depending on its linked economic index and your loan terms. In most cases, the floating interest rate increases after the fixed period ends, which means a homeowner’s mortgage payments will increase, too.

Many homeowners take out ARMs when they plan on moving or refinancing their ARMs into fixed-rate home loans before the fixed period ends.

But what if home prices fall? If your home decreases in value, you may not be able to refinance your ARM because you won’t have enough equity in your home. And what if your plan to move changes, or you can’t find a buyer for your home in time? Once the fixed introductory period ends, your ARM will switch to an adjustable rate before you can leave.

It’s essential to consider all scenarios. Make sure you have enough padding in your budget to accommodate a higher mortgage payment if you can’t refinance or move as planned. 

Fixed Interest Rates And Your Mortgage

The potential challenges with floating interest rates are why most homeowners gravitate toward fixed-rate mortgages. With a fixed interest rate, your monthly principal and interest payments won’t fluctuate over the life of the loan – though changes with property taxes or homeowners can cause your mortgage payment to rise or fall. Because the monthly payment is predictable, it’s easier to factor it into your budget.

However, fixed-rate mortgages have some drawbacks to consider. They typically have slightly higher interest rates than ARMs during the introductory period. Because lenders can’t change the rate, they usually set a higher one to account for potential market rate increases over the loan’s term. Higher rates will translate to higher monthly mortgage payments you can’t change until you refinance.

You can use a mortgage calculator to estimate your monthly payment or research current mortgage rates.

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When A Floating-Rate Mortgage Might Be The Right Option

When does a floating interest rate make sense? A floating interest rate may be appropriate if you find yourself in one of the following situations.

You Plan To Move In The Next Few Years

An ARM makes sense if you plan on moving before the loan’s fixed introductory period ends. This strategy allows you to take full advantage of the ARM’s lower initial interest rate. But if you can’t sell your home in time, your loan will likely convert to an adjustable rate, and you may need to cover a higher monthly payment (you might also have a lower payment if the ARM adjusts down).

You’re Purchasing A Starter Home

Many new buyers purchase starter homes they only plan to live in for a few years. Usually, the goal is to build equity in the house and then sell it for a profit to buy a larger home. A loan with a floating interest rate might make sense when you plan on living in your starter home for a few years before selling it and applying for a new mortgage.

Interest Rates Are Higher Than Usual

Consider an adjustable-rate mortgage when mortgage interest rates are high to get a lower interest rate than you would with a standard fixed-rate loan. You can refinance your adjustable-rate mortgage once mortgage interest rates fall again. However, the risk is that rates may not fall, or you won’t have enough equity in the home to refinance before the ARM’s introductory period expires.

What Types Of Mortgage Loans Does A Floating Rate Apply To?

Consumers can apply for several types of home loans when they’re ready to finance the purchase of a house, but not all mortgages have a floating-rate option. You can expect the following rate options with these mortgages:

  • Conventional loans: This home loan has two interest rate options: fixed and adjustable. Because the U.S. government doesn’t back conventional mortgages, they typically have higher interest rates than other loan types.
  • FHA loans: This option allows borrowers to choose between a fixed or floating interest rate. Federal Housing Administration (FHA) loans are known for lower rates and more relaxed down payment requirements.
  • VA loans: Qualified active-duty service members, veterans and eligible surviving spouses can get an adjustable- or fixed-rate Department of Veterans Affairs (VA) loan. VA loans offer competitive interest rates and have more flexible eligibility criteria.
  • Jumbo loans: In most areas, any loan higher than $726,200 is considered a nonconforming jumbo The loan’s rate can be fixed or adjustable.

Before you choose a home loan, thoroughly research all your options to make sure the mortgage you go with is right for you.

FAQs About Floating Rates

If you want to learn more about floating rates and how they affect mortgages, look no further than these frequently asked questions.

Are floating interest rate loans risky?

A floating interest rate carries some risk. The interest rate can increase throughout a loan’s term, leading to higher monthly payments that can strain a household budget. Fortunately, floating-rate loans have built-in protections to protect borrowers from steep interest rate hikes. Adjustable-rate mortgages typically have lifetime caps that dictate how high the interest rate can adjust.

What other indexes can be used as a reference for a floating interest rate?

Your lender can choose from several indexes besides the prime rate and federal funds rate as a reference for a floating interest rate. In the past, some lenders used the London Interbank Offered Rate (LIBOR). Today, many lenders use the 1-year constant maturity Treasury (CMT) or the Secured Overnight Financing Rate Data (SOFR).

How can I qualify for a floating interest rate?

You can apply for initial approval to find out what rates you qualify for. Qualifying for an ARM is generally the same as qualifying for a fixed-rate mortgage.

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The Bottom Line

While using a floating interest rate can be riskier than a fixed rate, this type of financing offers low initial mortgage rates and monthly payments and can save you a lot of money. That said, a fixed-rate mortgage might be better for buyers who want predictable payments or plan to stay in their homes for a long time.

If you’re interested in refinancing your mortgage, you can start today with an online application.

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Dan Rafter

Dan Rafter has been writing about personal finance for more than 15 years. He's written for publications ranging from the Chicago Tribune and Washington Post to Wise Bread, RocketMortgage.com and RocketHQ.com.