Introduction

When considering taking out a loan, it is essential to understand all the factors that influence your options and how they do so. Interest rates are one of the most important of these factors because they directly affect the cost of borrowing and the repayment structure.

Interest rates typically fall into two categories: fixed and floating. Fixed rates remain unchanged throughout the loan term, offering predictability and stability in loan repayments.

Floating rates, on the other hand, fluctuate based on market conditions. This can affect your payments over time.

In this article, we’ll delve into what floating rates are, how they are calculated, and explore their advantages and disadvantages to help you make informed financial decisions.

What Is a Floating Rate?

The meaning of a floating interest rate, also known as a variable interest rate, refers to the fact that the rate changes throughout the debt repayment period. This rate is linked to an external benchmark which is outside the control of the lender and the borrower.

The benchmark could be a reference rate such as the “Prime Rate”. It is the lowest possible interest rate provided by a financial institution to its most creditworthy clients. When the benchmark rate changes, the floating rate adjusts accordingly. For instance, if the benchmark rate increases, the floating rate will also increase.

Factors influencing the benchmark rate include government policies, inflation, fiscal deficits, and global interest rates. These elements, in turn, affect the floating interest rate.

Floating Rate Calculation

Now that you have understood the floating interest rate meaning, let’s understand how it is calculated. To do so, you have to understand the primary factors that influence the changes in the floating rate:

• Repo Rate - This is the rate at which the Reserve Bank of India (RBI) lends money to financial institutions and commercial banks against government securities.
• Central Bank Policies - These are monetary policies set by central banks and the government. 
• Market Economic Conditions - These include conditions like inflation rate and fiscal deficit.

Uses of Floating Rate

Floating rates fluctuate over time and can offer advantages over fixed-rate loans, especially in the long run. Borrowers may benefit from lower interest rates when market rates decrease, potentially making borrowing less expensive over extended periods like mortgage terms. Common uses of floating rates include:

• Home Loans -  Floating rates are popular for home loans, often calculated based on a reference rate like the prime rate.
• Credit Cards - Credit card companies frequently offer floating rates, which typically include the prime rate plus a spread rate.
• Corporate Companies - Large corporations often receive floating rate offers from financial institutions due to their generally strong creditworthiness. These companies often prefer floating rates for short-term financing as they may benefit from market rate movements.

Benefits of Floating Rate

Floating interest rates come with several financial advantages:

• Lower Initial Interest Rates - Floating rates tend to be lower than fixed-rate loans at the outset. Even if the rates rise over time, borrowers may still pay less overall compared to a fixed-rate loan, especially if rates remain low during part of the repayment period.
• Lower EMI Payments - Due to lower initial interest rates, borrowers often have lower EMIs, reducing the monthly outflow.
• Benefit from Rate Declines - If market conditions cause interest rates to drop, borrowers have the advantage of paying lower interest, reducing the total loan cost.
• No Prepayment Penalty - Most floating rate loans do not have a prepayment penalty, allowing borrowers to pay off the loan faster without incurring extra costs.

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Conclusion

Understanding the floating rate meaning and how it works is crucial, especially if you are considering long-term financial commitments such as a home loan. Floating rates can offer more affordable options for borrowers if market conditions are favourable, making them a popular choice for such products.

At SMFG Grihashakti, we offer home loans of up to INR 1 crore* at competitive floating interest rates starting from 10%* per annum (subject to revision in the Retail Prime Lending Rate and our policies). Please check our ROI page to know more. Our free-to-use home loan EMI calculator can help you stay on top of your budget planning with the ability to see the impact of different interest rates on the monthly payments. Apply online today or contact us for more information.