Floating Interest Rate: What to Know

Mortgages and many other loan products come with floating-rate options that function differently from fixed-rate products. Floating interest rates can change over time and impact your monthly payment and overall borrowing costs.

Float-rate loans may be great options for some, and not-so-great choices for others, but once you know how they work, how they can vary, and the risks associated with them, you’ll be able to determine if they’re a good fit for you.

What Is a Floating Interest Rate?

A floating interest rate, also known as a variable interest rate, changes over time during the life of the loan. Fluctuations follow changes in a benchmark or reference rate. For consumer mortgages, the benchmark is typically the Secured Overnight Financing Rate (SOFR) or a Treasury-based index (such as the 1-year Constant Maturity Treasury rate), not the prime rate. The prime rate is more commonly used as the benchmark for credit cards and Home Equity Lines of Credit (HELOCs), and is typically tied to the federal funds rate set by the Federal Reserve. For market and commercial lending, it’s more common for SOFR to serve as the benchmark.

Your floating interest rate is made up of the reference rate, plus your personal margin, or “spread”, which is a fixed percentage established by your lender that’s applied to the benchmark. Because a floating rate is contingent on an index rate—subject to periodic changes based on economic indicators and market changes—borrowers might notice rate increases as this benchmark rises and rate drops as it falls.

Examples of Floating Rate Loans

Here are some of the most common examples of floating rate loans:

• Adjustable-rate mortgages (ARMs)
• Home Equity Lines of Credit (HELOCs)
• Private student loans
• Variable-rate credit cards
• Leveraged bank loans

While many personal and student loans usually come with fixed interest rates, lenders may also have unsecured borrowing options with variable interest rates. Before settling on a loan program, consider how unpredictable monthly payments could impact your future financial goals.

How Does a Float Rate Differ from a Fixed Rate?

Here’s a closer look at how floating rates differ from fixed rates:

Your homeownership goals and financial status will determine which mortgage is best for you. It can be useful to compare fixed-rate and ARM mortgages before purchasing a property.

Who Should Consider a Floating Rate?

For borrowers only looking to move or sell their home shortly after borrowing, whether it be to relocate or downsize, floating rates offer the chance to save money during a rate drop, or if you sell before reaching the adjustment period. If you’re a first-time homebuyer or someone expecting an improved financial situation in the coming years, you’ll save when rates are low and still be able to cover monthly payments when rates increase.

Additionally, if you anticipate a drop in mortgage interest rates, you might want to consider a floating rate. Should rates fall, you could lock in a lower rate by refinancing before significant rate adjustments take place.

How Does a Float-Rate Mortgage Work?

Floating-rate mortgages usually have an introductory or “fixed” period with a lower interest rate than your average fixed-rate loan. This period can last anywhere from a few months to a few years, depending on your lender. Once this window is over, your new rate is calculated by adding your margin to the index rate.

From here, your rate may increase or decrease based on the benchmark rate. During this phase, your personal mortgage rate will only adjust annually, or every 6 months, based on the terms of your agreement.

Floating-Rate Mortgage Payment Example

To visualize exactly how this type of mortgage works, take an example buyer who purchased a $400,000 home with 3.50% down and a 30-year FHA 5/1 ARM. The index at closing was 3.6% with a 2.25% margin. For the five-year introductory phase, the loan has a 6% (7.087% APR) interest rate before it starts adjusting annually. This loan could change as much as 1% higher or lower beginning on year 6, and will only adjust once per year. Under the FHA 5/1 ARM's lifetime cap of 5 percentage points, the rate will never be lower than 2.250% nor will it ever go higher than 11%.

• First five years: The monthly principal and interest payment will be $2,354.76.
• Sixth year, interest rates rise to 6.5%: The principal and interest payment will be $2,467.65.
• Seventh year, interest rates drop to 5.50%: The principal and interest payment will be $2,250.36.

You see that the owner’s monthly payments changed 2 times in 7 years, meaning your monthly payments could also change as the index rate changes. If index rates begin to spike, or if you just want to consider other options, you can refinance to a fixed-rate loan to lock in a specific rate and change your loan terms.

Floating Interest Rate Mortgage FAQs

Here are a few more questions you may have about floating interest rate mortgages:

When Do Floating Interest Rates Change?

The interest rate that determines your monthly payments will only change during the adjustment period. These adjustments can happen monthly, every 6 months, or annually; it all depends on the terms of your loan and your lender's advice.

What Are the Risks of Floating Rates for Mortgages?

The biggest risk of a floating mortgage is its unpredictability. Your monthly payments depend on large-scale economic and market conditions, meaning you have no control over how your rate and payments will change. These concerns could be enhanced if you’re on a fixed income.

There’s also a chance that during the application process, you lock in a rate, only for the market to significantly improve by the time your lender processes the loan. Some lenders may offer a “float down” mechanism in these cases, which may bring your rate down to current market pricing.

Are There Caps to Floating Interest Rates?

Yes, there are caps on floating rates. A rate cap is a limit on how much your rate can increase each time your index rate changes, and rate “floors” are limits on how much it can decrease. There are separate caps for lifetime rate increases and decreases. These boundaries are determined by your lender or the loan program and are in place to protect you against volatile market fluctuations.

Can You Switch from a Floating to a Fixed-Rate Mortgage?

Yes, you can switch from one set of terms to another with a refinance or conversion. A refinance involves paying off the existing loan and replacing it with a new one with different terms. If your lender offers them, or if it’s disclosed in your initial mortgage agreement, a conversion allows you to switch to a fixed-rate loan by paying a conversion fee. Remember that your new interest rate following a refinance or conversion will reflect the market rate at that time.

Final Thoughts: Is a Floating Interest Rate Right for You?

Floating rates offer a unique set of benefits for those who utilize them. You can take advantage of the introductory period’s low interest rate and refinance or sell while your payments are low. Once rates begin adjusting, they’ll only change periodically according to the terms of your agreement.

Understand that these options do pose risks, and that floating rates can be unpredictable at times, especially if you borrow during a less-than-stable economic period.

If you’re ready to see which of these options you qualify for, get prequalified online today.

Disclaimer: APR of 7.087% assumes 4% in discount points, average prepaid finance charges (including UFMIP) of $8,094.24, an index starting at 3.60%, and a margin of 2.25%. This ARM would only change 1 time per year after the introductory period at a maximum of 1 percentage point higher or lower and assumes a margin of 2.25%. This interest rate illustrated would never go lower than 2.25% or higher than 11.00%. All values were based on Indiana FHA loans.