FLOATING INTEREST RATE
WHAT IS A FLOATING INTEREST RATE?
Floating interest rate refers to a variable rate that changes over the tenure of the debt obligation. It is the exact opposite of the fixed interest rate where it remains constant throughout the tenure of the debt. Loans such as home loans can be acquired at both fixed and floating rates that periodically adjust as per the market conditions.
CALCULATION OF FLOATING RATE
It must be noted that several factors tend to influence the calculation of floating rates which includes:
- Inflation rate
- Repo rate
- Fiscal deficit
- Monetary policies of the government
- Foreign and Global interest
The interest rate of this kind are subjected to changes and the calculations can often be complex. So it is always a better alternative to calculate this with the help of a loan EMI calculator or an investment calculator.
RELEVANCE OF FLOATING INTEREST RATE
1. Banking Industry:
Floating rate loans are common products in the banking industry for large corporate loan seekers. The total rate paid by them is decided by adding (or in some rare cases, subtracting) a margin or spread to a specified base rate.
2. Mortgage Loans:
Floating interest rates are used most often in mortgage loans. An index or reference rate is followed, with the floating rate calculated as, for instance, ‘the prime rate plus 1.5%’.
3. Credit Cards:
The credit card entities may also offer floating interest rates. These rates charged by the bank are usually the prime rate plus a certain spread.
Investors can choose an investment alternative with floating interest rates when they anticipate the base rate will be the same or a change will be in favor. Under such circumstances, the interest earned either stays the same or is likely to go up.
MERITS OF FLOATING INTEREST RATE
1. Reduced cost of borrowings:
Usually, floating interest rates are lower compared to the fixed ones and hence assist in reducing the overall cost of borrowing for the debtor.
2. Unexpected gains:
There is always a window for unexpected gains. With higher risk also comes the chance of future gains. The borrower will enjoy benefits if interest rates go down. The lender will enjoy the addition because he can then raise the floating rate charged to the debtor.
3. No Penalty:
No prepayment penalty is levied on loans carrying floating interest rates. This helps borrowers to pay off quickly without adding the burden through penalty.
DEMERITS OF FLOATING INTEREST RATE
1. Unexpected rise in loan rate:
The interest rate depends largely on market scenarios which can prove to be unpredictable and dynamic. Hence, the interest rate may go up and increase to a point that the loan may become difficult to repay.
2. High charge:
In times of unfavorable and adverse market scenarios, financial institutions try to be in a safer place by putting the burden on customers. They will charge a high premium over the index/benchmark rate, ultimately affecting the borrowers' pockets.
3. Complex budgeting:
The unpredictability and uncertainty of interest rate changes make budgeting more complex for the borrower and also for lenders to accurately forecast the cash flows.
QUICK COMPARISON TABLE
|Floating Interest Rate||Fixed Interest Rate|
|Lower interest rate||Higher interest rate|
|EMIs changes as per MCLR or interest rate||Fixed EMIs|
|Affected by changes in the financial market||Not affected by financial market conditions|
|Higher risk||Lesser risk|
|Suitable for long term (20-30 yrs)||Suitable for short-medium term (3 to 10 yrs)|
|Generates savings||Sense of security|
|Difficult to manage or budget financials||Budget planning possible|
Interest rates are some of the most significant components of the economy. They help in shaping day-to-day decisions of investors and corporations such as determining either it is a good time to take out a loan, buy a house or put money in savings. The level of interest rates is inversely proportional to the borrowing levels which ultimately affects economic expansion. Interest rates influence bond markets, stock prices, and derivatives trading.