Financial Glossary Header Image

Floating rate of interest

Updated on October 4, 2023

Fixed rate of interest and floating rate of interest are the two broad categories of interest classification on loans. Read on to get a brief explanation of the floating rate of interest and its relevance to loans.

Meaning of Floating Rate of Interest

A floating rate of interest, also known as a variable or adjustable rate of interest, is a type of interest rate applied to a loan that can change periodically over the course of the loan’s term. Unlike a fixed interest rate, which remains constant, a floating rate is typically linked to a reference benchmark interest rate or an index, such as the Marginal Cost of Funds Based Lending Rate (MCLR) or the Repo Rate

What are the key features of a Fixed Rate of Interest?

Floating interest rate loans are characterized by their variability, with interest rates subject to fluctuations linked to benchmark rates like the Reserve Bank of India’s Repo Rate. These loans often start with lower initial interest rates than fixed-rate counterparts, appealing to those seeking reduced initial payments or anticipating benchmark rate declines. Rate adjustments occur at varying intervals, typically every three to six months in India, as stipulated in the loan agreement. Borrowers should note that floating-rate loans are sensitive to broader economic conditions and may see rate increases in response to market shifts. Such loans consist of two components, namely, the variable benchmark rate and a fixed lender-specific margin. The combined sum of these factors determines the loan’s interest rate.

What are the points borrowers should consider while taking a fixed rate of interest?

Individuals considering a floating rate loan should exercise caution and take into account several critical factors. Borrowers should evaluate the potential for rate volatility, as floating rates can result in monthly payment fluctuations over time, and assess their ability to manage potential rate increases. Moreover, staying informed about economic conditions and central bank policies that can influence benchmark rates is essential, enabling borrowers to anticipate potential interest rate shifts. Lastly, despite the flexibility offered by floating rates, having a well-defined budgeting strategy in place is advisable to effectively manage any variations in monthly payments.