A floating interest rate moves in concert with an index or other factor to which it is linked, such as the Consumer Price Index. Floating rates are usually altered at fixed intervals, such as once a month or quarter. Between these periodic adjustments, the rate is fixed. Loans with floating interest rates are typically less expensive for the borrower, because the borrower is taking on the risk that the interest rate could increase. Conversely, when a loan has a fixed rate, the rate is usually higher because the lender is taking on this risk. A lending arrangement may incorporate an interest rate cap, so that rate increases cannot increase beyond a specific amount; this cap transfers some of the interest rate risk to the lender.
Floating rates can work well when the underlying debt is expected to be of short duration. In this case, there is only a short period of time over which the rate could increase. Since lenders frequently offer low introductory rates for floating rate loans, this means that a borrower could pay a relatively low rate over the life of the loan. There is also a possibility that a floating rate could decline. However, the risk associated with floating rates increases with the duration of the loan, since there is more time for the associated index to experience a rate spike, which will be reflected in the interest rate.
An example of a floating interest rate is the rate associated with many credit cards, which fluctuates on a monthly basis. Homeowners can also opt to incorporate a floating interest rate into their mortgages, though doing so exposes them to potentially large rate increases over the life of the loan.
A floating interest rate is also known as a variable interest rate or adjustable interest rate.