What is a Floating Interest Rate?

When you avail a personal loan, you must consider various factors like your existing debt, the loan amount and tenure, your ability to repay the loan, and the type of interest charged by the lender- fixed interest rate or floating interest rate.

Understanding the type of interest rate is crucial as this will impact your personal loan repayment amount. Here, we will talk in detail about floating interest meaning, how it works, the factors affecting the floating interest rate and how it is different from the fixed interest rate.

What is a Floating Interest Rate?

Otherwise called a variable interest rate, a floating interest rate, in simple words, is the interest rate that can change over a period of time. Unlike fixed interest rates, it is not constant and hence, it fluctuates on the basis of various factors such as market conditions, central bank policies, etc.

How Does Floating Interest Rate Work?

Floating interest rates are often based on a benchmark rate. Let’s understand it with an example. Consider, you take out a loan with a floating interest rate. Now, in this scenario, let’s keep it at 5%. This 5% would be the prime rate which you would be paying on your loan initially. However, if the market conditions fluctuate and the prime rate changes to 7%, then you would be bound to pay a 7% interest rate on your loan. This would however change your monthly payment, keeping the repayment schedule the same.

Factors Affecting Floating Interest Rate

Here are some factors that are responsible for changing the floating rate:

  • Economic conditions (it may include inflation, unemployment, GDP growth, etc.)
  • Central bank policies (monetary policies set by central banks)
  • Market conditions (perceptions of investors in the market)
  • Credit risk (your creditworthiness)

Also Read: How Having Multiple Credit Cards Can Affect Your Credit Score

Floating Interest Rate Vs Fixed Interest Rate

Aspect Floating Interest Rate Fixed Interest Rate
Flexibility Flexible as the interest rate may change as per market conditions. No flexibility as payment remains the same throughout the loan tenure
Protection against interest hike No protection Provides protection against interest hikes
Monthly payments Changes as per change in interest rate Remains constant

Pros of Floating Interest Rate

  • Floating rates allow you to take advantage of falling interest rates and this helps in saving on interest payments.
  • In a low-rate environment, floating rates may offer lower initial payments compared to fixed rates.
  • Floating rates are always according to the current market conditions

Cons Of Floating Interest Rate

Advantage of Floating Interest Rate
  • You can face the risk of rising interest rates and this can lead to higher monthly payments and increased borrowing costs.
  • It becomes harder for you to budget and plan for future expenses during market fluctuations.

Also Read: Emergency Personal Loans: What You Need to Know

Conclusion

So, now that you understand floating interest rates and how they are different from fixed interest rates, you can make your decision wisely while opting for a personal loan, two-wheeler loan, etc. Consider your financial goals, risk tolerance, and market conditions before going with a fixed interest rate or floating interest rate. Always weigh the pros and cons of your decision before coming to a conclusion.

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