What it means
A floating rate loan does not state a single fixed percentage. Instead it says something like "the reference rate plus 250 basis points", where a basis point is one hundredth of a percentage point, so 250 basis points is 2.50%.
The reference rate is looked up at each reset date, the margin is added, and that becomes the rate for the next period. This structure exists because lenders fund themselves at market rates too.
If a bank's own cost of money rises and its loan book is fixed, it loses; tying loan rates to a benchmark passes that movement through to borrowers. The margin on top is what the lender earns for credit risk, administration and profit.
Reference rates appear in far more than loans. They set the floating leg of interest rate swaps, the coupon on floating rate notes, the interest on many leases and intercompany balances, and the discount rate in some valuation work.
Because trillions of dollars of contracts point at them, their integrity is treated as a matter of financial stability rather than mere convenience. That integrity concern drove a major change.
The old LIBOR family of rates was based partly on banks' submitted estimates, proved vulnerable to manipulation, and has been replaced by rates calculated from actual overnight transactions, such as SOFR and SONIA. These successors are close to risk free and backward looking, which is why contracts now often use a compounded average over the interest period rather than a single forward-looking quote.
For a borrower the practical implications are about protection. Contracts frequently include a floor, so the rate cannot fall below zero, and borrowers can buy a cap that limits how high the total rate can go.
Understanding which reference rate applies, how often it resets and whether any cap or floor is in place tells you almost everything about how exposed you are to rate movements.
In practice
Real-world examples
Example 1
A logistics firm agrees a five year term loan at the reference rate plus 300 basis points, resetting every three months. Its finance director models the budget at three rate scenarios rather than one, because a two percentage point move on a $4,000,000 balance changes annual interest by $80,000.
Example 2
A commercial landlord issues floating rate notes to fund a development, paying investors the reference rate plus 175 basis points. Investors accept a lower margin than a fixed rate bond would need because their return rises automatically if market rates climb.
Example 3
A multinational sets intercompany loan pricing at the relevant local reference rate plus a documented margin, so that tax authorities in each country can see the terms are comparable to what an unrelated lender would charge.
Think of it
Think of a reference rate like the local speed limit on a motorway. Your car's actual speed is that limit plus whatever extra speed you choose to drive. When the government lowers the speed limit sign, your entire driving speed drops down with it.
Formula
Calculation
All-in interest rate = reference rate + margin. Annual interest cost = principal x all-in rate.
Ravensworth Foods has a $6,000,000 revolving facility priced at the reference rate plus 250 basis points, resetting quarterly. At the first reset the reference rate is 4.30%, so the all-in rate is 4.30% + 2.50% = 6.80% and the annual interest cost is $6,000,000 x 6.80% = $408,000.
A year later the reference rate has risen to 5.30%. The all-in rate becomes 5.30% + 2.50% = 7.80% and the annual cost rises to $6,000,000 x 7.80% = $468,000, an increase of $60,000 without the company borrowing an extra dollar. Had Ravensworth bought an interest rate cap fixing the all-in rate at a maximum of 7.50%, its cost would have been capped at $6,000,000 x 7.50% = $450,000, saving $18,000 that year against the premium it paid for the cap.Case study
Seen in the real world
Crayford Care Homes is an invented business used here to illustrate reference rate exposure. It financed four homes with $6,000,000 of floating rate debt at the reference rate plus 250 basis points, and when it signed, the reference rate stood at 4.30% for an all-in cost of 6.80% and $408,000 of annual interest. Its operating profit was $950,000, giving interest cover of roughly 2.3 times against a covenant requiring 2.0 times.
When the reference rate rose to 5.30% over the following year, interest climbed to $468,000 and cover fell to about 2.0 times, right at the covenant limit. Fee income from local authority placements was contractually fixed for the year, so the company could not simply raise prices to compensate.
Crayford negotiated a two year interest rate cap at an all-in level of 7.50%, paying an up-front premium, and reset its budgeting to assume the capped rate rather than the prevailing one. In this fictional example the cap did not make the debt cheaper; it made the worst case knowable, which was what the covenant test actually required.
Watch out
Common mistakes
- Budgeting a floating rate loan at today's rate for the whole term, which leaves no allowance for resets that can add tens of thousands to the annual cost.
- Confusing the reference rate with the rate you actually pay, when the margin your lender adds can be larger than the benchmark itself.
- Assuming all reference rates behave the same way, when overnight rates such as SOFR are compounded backwards over the period rather than quoted forward like the old LIBOR settings.
Questions
People also ask
What is a basis point?
One hundredth of a percentage point, so a margin of 250 basis points means 2.50% added to the reference rate.
Should I choose a fixed or floating rate?
Floating usually starts cheaper and suits businesses that can absorb variation, while fixed buys certainty at a price and suits those with tight covenants or thin margins.
What happened to LIBOR?
It was withdrawn after weaknesses in how it was compiled came to light, and contracts moved to rates calculated from actual overnight transactions such as SOFR and SONIA.