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Floating interest rates: What they are, pros, and cons

A floating interest rate changes over time based on market conditions, creating monthly mortgage payments that can eventually rise or fall.

Floating or adjustable interest rates often start lower than fixed rates, potentially reducing the loan's initial monthly payments and helping borrowers qualify for a larger loan amount.

This benefit has a tradeoff. Monthly payments can increase if interest rates climb, affecting your monthly budget and long-term financial planning.

Savvy borrowers can benefit from a floating rate without facing its higher interest rate risks.

What is a floating interest rate?

A floating interest rate adjusts up and down over time based on current market conditions. Lenders may use terms like variable, adjustable, or flexible rates to describe floating interest rates.

Mortgages with floating rates are typically called adjustable rate mortgages, or ARMs. These loans provide an alternative to fixed-rate loans. 

Floating interest rate vs. fixed interest rate

The key difference between floating and fixed-rate mortgages comes down to predictability versus potential savings.

Loans with floating rates generally save money during the earliest years of the loan term because they open with an introductory rate that's lower than fixed rates.

Then, once the introductory rate expires, the loan's mortgage rate will change each year to match market conditions.

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How does a floating interest rate work?

Floating rates don't change haphazardly. Instead, they track a rate index such as the Secured Overnight Financing Rate (SOFR), effective federal funds rate (EFFR), or London Interbank Offer Rate (LIBOR).

This index, or benchmark, provides a reference rate for the mortgage. Then the lender adds its spread or margin. Lendersbase this spread on the loan's credit risk. 

Floating Rate = Benchmark Rate + Spread

Adjustment periods

A floating rate changes at pre-set intervals: quarterly, semi-annually, or annually, depending on the loan terms. Borrowersan often understand a rate's scheduled changes by looking at the loan's name.

A 10/1 ARM, for example, adjusts annually after its initial 10-year fixed rate period ends. A 5/1 ARM features a 5-year intro period followed by annual rate changes.

Rate caps

Modern floating rate loans build in features to protect borrowers from volatility. Rate caps, for instance, control how high the loan's rate can float. Current ARMs come with three different rate caps:

• Initial rate cap: Controls how high the rate can float after its introductory period expires
• Annual rate cap: Controls how high a rate can climb from year to year
• Lifetime rate cap: Sets a limit on how high the rate will ever float

Initial adjustment caps often limit rate increases to 2 percent during the first adjustment, while lifetime caps often restrict total rate increases to 5 to 6 percent above the starting rate.

The effect of rate changes

Even small rate increases can make a big difference to borrowers. A 1 percent rate increase on a $400,000 mortgage typically adds about $240 to the monthly payment.

Before committing to a mortgage with a floating rate, use a mortgage calculator to see how much payments would climb with different rate scenarios.

Rates can fluctuate down, too

Floater rates can go down as well as up. If the adjustable rate loan's index rate falls before the ARM's next rate adjustment, payments could go down for the next year.

Refinancing an ARM adds stability

Borrowers with floating rate loans can stop the fluctuations by refinancing their ARM into a fixed rate loan. 

A Better preapproval will show how much a refinance would cost based on a soft credit check that won't hurt your credit score.

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Pros and cons of floating interest rates

Most home buyers get a fixed-rate mortgage to avoid dealing with floating rates. Buyers on a fixed income, don't want to risk interest rate changes.

Other borrowers may want to consider the savings a floating rate can offer during the early years of a loan.

Pros of floating interest rates

Floating rates appeal to borrowers because these loans have:

• Lower initial rates: Many borrowers can qualify for a lower floating rate when compared to fixed rates. This reduces monthly payments and may allow a bigger loan amount.
• Modern rate caps: Unlike floating rate loans before 2008, today's ARMs come with rate caps to protect borrowersfrom out-of-control rate spikes.
• The potential for rate drops: When market rates fall, payments decrease automatically without needing to refinance, potentially saving thousands over your loan term. Essentially, a floating rate loan is a loan that refinances itself periodically. 
• Flexibility for short-term ownership: If you plan to sell within five to seven years, for instance, you could take advantage of lower initial rates without worrying about long-term volatility.
• Ability to refinance: Homeowners can leave their floating interest rates behind by refinancing into a fixed rate loan, selling the home, or paying off their loan early. 

Cons of floating interest rates

Floating rates scare borrowers because of their:

• Payment uncertainty: This is the biggest con for many homeowners. If interest rates rise by only 1 percent, the payment on a $400,000 mortgage would cost about $240 more each month. 
• Budgeting challenges: Volatility makes household budgeting, especially in times of rising interest rates.
• Potential for higher long-term costs: If rates climb and stay elevated, borrowers whose rates fluctuate could be stuck with years of higher payments, adding thousands of dollars to their overall loan costs.
• Stress factor: Rate fluctuations can create anxiety for homeowners who prefer predictable monthly obligations.

Remember, you can always refinance an ARM loan later.

How to calculate a floating interest rate

Understanding how lenders calculate your floating rate helps home buyers predict payment changes and plan ahead.

1. First, find your loan's benchmark or index rate. Ask your loan officer if you're in the process of buying a home. If you've already closed the loan, the loan servicer will know.
2. Find your loan's spread or margin. This is the interest rate the lender adds to the benchmark rate. It'll likely be based on your credit risk as a borrower.

For example, if the index rate is 4 percent and the margin is 2 percent, the loan's rate will float to 6 percent.

But don't forget rate caps

The ARM's rate caps will limit how high a rate can float. Even if the market interest rates increase the benchmark by 5 percent, the loan's caps will limit how much of that rate increase borrowers experience.

For example, if the loan's initial rate cap is 2 percent, the interest rate can't climb higher than 2 percent when it floats for the first time. Even if the index plus the margin calls for a 3 percent increase, the new interest rate will not climb more than 2 percent. 

Along with initial rate caps, floating rate loans also cap how high a rate can climb on subsequent adjustments and how high it can climb throughout the life of the loan.

When choosing a floating interest rate might be a smart move

Floating rates aren't right for everyone, but they can deliver significant savings to borrowers who understand how they work and use these loans to their advantage.

You might want to consider a variable rate loan if:

You expect to move shortly

Planning to sell your home within a few years? A 5/1 ARM could save you thousands compared to fixed-rate loans. Since floating rate mortgages typically start with lower initial rates, you'll benefit from reduced monthly payments during your ownership period.

This strategy works because you'd sell the home and pay off the mortgage before potential rate increases affect your budget. For example, if you save $200 monthly with a floating rate and sell within three years, that's $7,200 in your pocket.

What if you change your mind and decide not to move? You can always refinance the ARM to lock in a fixed rate.

You're buying your first home

First-time homebuyers might find floating rates particularly attractive for qualifying purposes. Lower initial monthlypayments can help you:

• Qualify for larger loan amounts: Reduced payments improve your debt-to-income ratio, potentially opening doors to homes you couldn't afford with fixed-rate financing.
• Overcome down payment challenges: The money saved on monthly payments can help build reserves for maintenance, improvements, or emergency funds.
• Maintain flexibility: You can always refinance your ARM loan once your income increases or your financialsituation stabilizes.

Rates are currently elevated

When fixed mortgage rates sit at elevated levels, floating rates position you to benefit from future market declines without taking any additional action. Rather than locking into high fixed rates, you can start with lower variable payments and capture savings as markets improve.

This approach requires monitoring market conditions and staying prepared to act. Check current mortgage rates to anticipate market fluctuations. If rates drop significantly, you'd be in a position to benefit without paying closing costs on a new refinance. 

Your home is part of a broader portfolio

Serious investors know they can earn more on their floating rate securities when interest rates rise. For example, a homeowner who holds floating rate bonds can use earnings from those investments to offset the risk of paying higher interest rates.

Home buyers should consult a financial planner before making these kinds of plans since earnings from investments are never guaranteed. 

Floating interest rates FAQs

Here are some answers to frequently asked questions about floating interest rate loans:

What's an example of a floating interest rate?

Credit cards offer the most familiar example of floating interest rates. Most card agreements state "this APR will vary with the market," typically tracking the prime rate. Adjustable-rate mortgages like a 10-1 ARM work similarly, using benchmarks such as SOFR plus a lender margin.

Fixed or floating interest rate, which is better?

There's no one-size-fits-all answer. Most home buyers like the predictability of a fixed rate loan. But some borrowers can claim the advantages of a floating rate without ever facing the higher interest rate risk. If you want to close a mortgage and forget about it for decades, a fixed rate is the way to go. If you like to strategize to get the most out of a loan, you may like a rate that fluctuates. 

Is a floating interest rate risky?

Floating rates introduce payment uncertainty. Monthly mortgage payments can increase if interest rates rise, potentially straining your budget. Modern adjustable-rate loans feature lifetime rate caps that limit the risk. Plus, borrowers can refinance to exit a volatile ARM. 

Floating rate vs fixed rate? Knowledge matters most

Floating interest rates present opportunity and uncertainty.

In either case, borrowers should understand their loan before finalizing it.

Better's transparent mortgage application helps home buyers know how much they'll pay to own the home.

Get started with a preapproval today and see your home buying budget before making any mortgage commitments or affecting your credit score.

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