Interest has always been a deciding factor when it comes to selecting a cost-effective funding option or a profit-earning investment scheme. However, besides the interest amount earned, the adjoining rate also plays a vital role in making a favourable decision. With that being said, individuals must make it a point to find more about interest types like – floating rate and fixed rate to make an informed decision.
Following is an elaboration of the fundamentals of floating interest rate meaning for investments.
In this article
What is Floating Rate?
The floating rate meaning suggests that it is an interest rate that tends to fluctuate with the market or on an index. The fact a floating interest rate may vary during the time horizon of an investment or debt tenure has earned it names like – variable, flexible or adjustable interest rate.
Notably, a change in floating interest rates depends entirely on a ‘benchmark’ or a reference that is beyond the control of the parties involved in an investment. This particular reference rate is a standard benchmark like the – prime rate. In case of floating rate on loans, the said benchmark is the lowest possible rate that commercial institutions levy on creditworthy borrowers.
When compared to fixed-rate debts, credit options that come with floating rates are relatively cost-effective in the long run, even though they depend on the yield curve. On the other hand, in case of investments with floating rates, individuals can generate stable and predictable returns on them over time.
Floating Rate Calculation
It must be noted that several factors tend to influence the calculation of floating interest rates. Some of the economic factors are given below –
- Repo rate
- Government’s monetary policies
- Inflation rate
- Fiscal deficit
- Global and foreign interest
Since the rate of this type of interest is susceptible to changes, the calculation can often be dubious. This is why it is better to calculate floating interest rate with the help of an investment or a loan EMI calculator.
When is Floating Rate Relevant?
Individuals can understand the relevance of floating rate under these situations –
- While applying for a loan
Typically, intending borrowers pick a loan with a floating rate when they expect a reduction in the interest rate or a dynamic rate through their loan tenure. Additionally, such an interest type enables individuals to make prepayments easily and pay off their debt faster and at a much lower interest burden.
- While investing
Individuals can choose investment instruments with floating rates when they anticipate the base rate will be the same, or an expected change will be in their favour. Under such situations, the interest earned on investments made either stays the same or is likely to increase. Nonetheless, individuals must make it a point to weigh the benefits of the variable interest rate to decide whether it will help them to save or earn more over time.
Benefits of Floating Rate
These following pointers highlight the major advantages of a floating interest rate –
For loan borrowers
- Floating rates on loan options are usually lower than fixed rates. As a result, even when the interest rates have increased through the course of repayment, the interest burden will still be lower than what accompanies loan options with fixed rates. In turn, it will help borrowers save more on their EMI payments.
- Though at times, floating rates may undergo an increase, it will not remain the same throughout the repayment tenure and will eventually come down in due time.
- No prepayment penalty is levied on loans with a floating rate. This helps borrowers to pay off their debt quickly and without adding to their repayment burden.
- Market fluctuations mostly work in favour of individuals investing in specific investment tools and provide them with unexpected gains. They can generate substantial earnings on their investment when the market booms and starts to recover rapidly.
- Both short-term and floating-rate bonds tend to perform well when then the interest rates are rising. Such investment options work in favour of investors as they help to lower the volatility of their investment portfolio.
Regardless, certain limitations accompany this type of interest rate and must be accounted for to make way around them.
Limitations of Floating Rate
Typically, these following drawbacks of floating rate limit its scope –
- The fluctuation of rate is beyond the control of both parties in a contract, namely – the lender and borrower in a lending institution setup. Similarly, investors and investment firms have to make their way around the fluctuations to generate earnings while cushioning their capital.
- Even the slightest increase in the interest rate can push loan EMI burden significantly for loan borrowers. It often makes the repayment process challenging and disrupts a functioning financial plan.
- A small decrease in the interest rate generates a return on investment which is much lower than what one had anticipated before. As a result, investors may take a longer time to reach their respective financial goals.
- Both borrowers and investors often find it quite challenging to manage their budget plan and regulate savings when dealing with a floating rate based financial or investment option.
Differences Between Floating Rate and Fixed Rate
|The interest rate may fluctuate throughout the loan tenure or investment horizon.||The rate of interest remains the same throughout the loan and investment tenure.|
|The fluctuations tend to influence the EMI amount and returns on investment.||The loan EMI remains fixed throughout.|
|Those who do not mind adjusting their budget and financial plan may be comfortable with this type of interest.|
Also, borrowers who wish to pay off their loan quickly and at zero prepayment charge often prefer this rate of interest.
|Those who follow budgeting and are comfortable with a fixed instalment schedule may find fixed interest investment suitable.|
To make the most of their investments or to manage their debt more conveniently, individuals must weigh in the pros and cons that accompany each interest type and proceed accordingly. They should also gauge the efficiency of their financial management plan and budgeting prowess before selecting a floating rate or fixed rate of interest.