One important factor to consider when applying for a loan is its interest rate. The interest rate plays a crucial role in every loan. Interest is the portion of the money that you will have to pay against the loan. It is calculated as the percentage sum of the loan.
In summary, a floating interest rate is an interest rate that changes as per market indicators. It is also known as a variable interest rate. Meanwhile, a fixed interest rate stays stable throughout the loan period.
What is a Floating Interest Rate?
A floating interest rate governs all debt instruments, like loans or mortgages, that do not keep a static interest rate throughout the loan tenure. A floating interest rate varies sometimes and moves up and down based on the market situation.
Floating interest rates change according to market conditions. Depending on the loan, there are various types of floating interest rates. It’s identical to a fixed interest rate if the rate doesn’t change much during a given period. However, over the long term, floating interest rates tend to vary significantly, which makes them different from fixed interest rates.
A floating interest rate is also called a variable or adjustable interest rate. It can alter throughout the debt obligation. The Alternate Reference Rate, also known as ARR, is a new reference rate released by the RBI in 2021 that is the basis for a floating interest rate.
How Does a Floating Interest Rate Work?
A floating interest rate is nothing but an interest rate that can change. It is generally in sync with the base rate given by the RBI. If you take out a loan with a variable interest rate, the rate can keep changing almost every quarter.
Floating interest rates depend on multiple economic indicators. These indexes include information given by banks and NBFCs. The interest on your loan also depends on the base rate released by the RBI. The base rate varies depending on various economic factors, which forces the floating interest rate to change accordingly.
With changes in the base rate, the interest rate on your loan will also alter. The economic indicator your lender uses is based on the loan you are applying for. It comes with some risks, like your interest rate rising during the loan period. This pushes your budget to the limits as the higher rate inflates your monthly payments.
For example, Ram and Vidya are buying a house, taking a loan of Rs 5,00,000, over 30 years, and the interest rate is 7:1. This implies their loan’s interest rate is set at 2% for the first seven years. After the expiration of time, the loan resets to have a floating interest rate, which reverses once a year. In the eighth year, the interest rate increased to 4%. In the ninth and tenth years, the interest rate falls to 3.7% and 3.5%, respectively. The interest they finally pay on the loan will change annually in this manner until they pay off the loan in full.
Advantages and Disadvantages of a Floating Interest Rate
Floating interest rates are very common these days. Especially if you take out a personal loan, most of these loans come with variable interest rates. Here are some pros and cons of floating interest rates.
Pros of Floating Interest Rate
The benefits of a floating interest rate are as follows:
- The greatest pro of a floating rate fund is its relation to changes in interest rates. This is compared to a financial tool with a static income or fixed bond voucher rate.
- Floating rates are normally lower than fixed rates. This entails that when the interest rates have increased through the course of paying back the loan, the interest burden will still be lower than what follows fixed loans.
- No prepayment penalty is charged on loans with a floating rate.
- Floating rate bonds perform well, interest rates will rise as they work in favor of investors. This helps to reduce the volatility of their asset portfolio.
It can be hard to agree on fixed or floating interest rates for a home loan. When it involves a short-term loan, it’s better to go for a floating rate. This is because you will be given a reasonable interest rate, and the interest won’t likely change greatly within a short period of time.
Cons of Floating Interest Rate
The disadvantages of a floating interest rate are as follows:
- It takes a long time for investors to reach their financial goals. This is because; a small reduction in the interest rate boosts a return on investment that is lower than what was expected.
- Both the lender and borrower find it quite problematic to stick to their budget and regulate their savings when dealing with a floating rate.
- If you can’t stick to a budget, it could lead to a longer loan period and more people not paying back their loans, which is a bigger economic risk.
Understanding the floating interest rate, how it works, and the benefits shared with you may have motivated you to make a financial loan decision. Are you considering applying for a loan to pay back at a floating interest rate because the interest burden is lower? We recommend Piramal Finance to guide you through the process.
Piramal Finance is an NBFC that offers financial guidance through a range of articles and blogs. It offers a variety of loans with a floating interest rate. Their interest rates are attractive, and they take the time to advise on which loan and interest rate are best for you. To know more about Piramal Finance, visit their website and check out the blogs and articles they have shared.