What it means
With a fixed rate loan, the rate is locked in. With a floating rate loan, the rate is reset at set intervals, such as monthly or quarterly, based on a reference rate that tracks market conditions.
The lender adds a fixed margin on top of that benchmark to reflect the borrower's credit risk and the lender's costs. The margin is agreed upfront and normally stays the same for the life of the loan, while the benchmark moves with the wider economy.
If central banks raise rates, the loan's interest cost rises soon after, and if they cut rates the cost falls. This makes the borrower's future interest bill uncertain.
Floating rates are common in business lending, including term loans, overdrafts, revolving credit facilities and many commercial mortgages. Borrowers like them because the starting rate is often lower than for a comparable fixed loan, and because they can usually repay early with little or no penalty.
Lenders like them because their own funding costs also move with market rates. The key risk for a borrower is that rates rise sharply, increasing interest payments just when conditions are tough.
Businesses manage this risk by budgeting with a buffer, by using interest rate swaps (contracts that exchange floating payments for fixed ones), or by buying a cap that limits the maximum rate. Some loans have built-in caps or floors.
Finance teams should model several rate scenarios when taking on a floating rate loan. Covenants, which are conditions in the loan agreement, such as a minimum interest cover ratio, can be breached if rates rise, so it is vital to stress test the numbers in advance.
Lenders often price floating loans using a benchmark that reflects short-term borrowing costs between banks, with a reset period of one, three or six months. The reset date matters, because the interest bill changes only when the rate is reset, not every day.
Borrowers should check the reset frequency and the name of the benchmark in the loan agreement.
In practice
Real-world examples
Example 1
A property developer takes a construction loan at a floating rate. The starting rate is lower than the fixed alternative, and the developer expects to repay the loan within two years. If rates fall during construction, the developer pays less, and if they rise, the developer has a buffer built into the budget.
Example 2
A retailer with a revolving credit facility pays interest on a floating basis only on the amount it has drawn. In quiet months, when the facility is barely used, the interest cost is small. The flexibility suits a seasonal business whose borrowing needs rise and fall through the year.
Example 3
A manufacturing firm worried about rising rates buys an interest rate cap on its loan. The cap limits the benchmark portion of its rate at 5%, so it can plan with a known maximum cost. The cost of the cap is a fee paid upfront, which the firm treats as insurance against a rate spike.
Think of it
A floating rate loan is like taking a canoe down a tidal river. When the tide goes out, you drift along easily with minimal effort. But when the tide turns and pushes against you, you have to paddle much harder to maintain your speed.
Formula
Calculation
Interest rate = Benchmark rate + Margin
Annual interest = Loan balance x Interest rate
Greystone Foods, a fictional manufacturer, borrows $2,000,000 at a benchmark rate of 3.0% plus a margin of 2.5%, so the rate is 3.0% + 2.5% = 5.5%. Annual interest is $2,000,000 x 5.5% = $110,000. If the benchmark rises to 4.5%, the rate becomes 4.5% + 2.5% = 7.0%, and annual interest is $2,000,000 x 7.0% = $140,000. The rate rise adds $140,000 - $110,000 = $30,000 to the company's yearly interest cost.Case study
Seen in the real world
Harvest Table is an illustrative, fictional restaurant group that borrowed $4,000,000 on floating terms to open new sites. The initial rate was attractive, and the owners planned their budgets around it.
Over the following eighteen months the benchmark rose by 3 percentage points. The annual interest bill increased by $120,000, which wiped out the profit of two of the new restaurants and brought the group close to breaching its interest cover covenant.
In the illustrative response, the finance director negotiated a swap to fix the rate on half of the loan and built a rate scenario table into the budget. The group kept the other half floating so it could still benefit if rates came down. The group now reports its fixed and floating split to the board each quarter, along with the effect of a one point rate rise.
Watch out
Common mistakes
- Budgeting interest at today's rate without allowing for a rise.
- Forgetting that the margin is added to the benchmark, so the rate is never just the benchmark alone.
- Ignoring covenant tests that may be breached when rates rise.
Questions
People also ask
What is the difference between floating and fixed rate loans?
A floating rate moves with a benchmark, while a fixed rate stays the same for an agreed period.
How can a borrower protect against rising rates?
Options include an interest rate swap, an interest rate cap or fixing part of the borrowing.
Who benefits when rates fall?
The borrower, because interest payments fall in step with the benchmark, though the margin stays the same.