Floating Interest Rate: Meaning, Advantages and Disadvantages

Borrowing money comes with choices, and one of the most important is the type of interest rate applied to your loan. Among the options, floating interest rates are common in home loans, personal loans, and other credit products. This blog will help you understand what a floating interest rate is, how it works, and when it might be a suitable choice for you.

What Is a Floating Interest Rate?

A floating interest rate is a type of loan rate that changes over time. It is not fixed and moves up or down depending on changes in a reference rate or market conditions. In India, many floating interest rates are linked to benchmark rates like the Repo Rate set by the Reserve Bank of India (RBI) or other lending benchmarks like the External Benchmark Lending Rate (EBLR).

This means that if the benchmark rate goes up, your loan interest rate can also increase. On the other hand, if it falls, your interest rate can go down too. Since it follows market trends, floating rates are also called variable interest rates.

How Does a Floating Interest Rate Work?

Floating rates usually include two parts:

1. Benchmark Rate: This is the base rate decided by the bank or financial institution. It could be linked to the RBI’s repo rate or another external benchmark.

2. Spread or Margin: This is an extra percentage added by the bank based on the borrower's risk profile and other factors.

For example, if the benchmark rate is 6.5% and your bank adds a 2% margin, your effective interest rate is 8.5%. If the RBI lowers the benchmark to 6%, your new rate becomes 8%.

Most floating-rate loans have regular review periods, such as every three or six months, when the rate is adjusted based on the current benchmark. Your Equated Monthly Instalment (EMI) or loan tenure may change depending on whether the rate goes up or down.

Floating Interest Rate vs Fixed Interest Rate

Understanding the difference between floating and fixed rates is key to making informed decisions.

Advantages of Floating Interest Rate

Floating interest rates offer several benefits:

• Lower Initial Rates: Banks often offer floating rates lower than fixed rates at the time of loan approval.

• Savings When Rates Fall: If the RBI reduces rates or the market interest declines, borrowers benefit from reduced EMIs or quicker loan repayment.

• No Prepayment Penalty: Most lenders do not charge fees for early repayment of floating-rate loans, allowing borrowers to reduce their debt faster.

• Long-Term Benefits: Over a long loan term, floating rates may result in lower overall interest payment compared to fixed rates.

Disadvantages of Floating Interest Rate

Despite the advantages, there are some downsides:

• Uncertainty: Future rates cannot be predicted, which creates financial planning challenges.

• Higher EMIs in Rising Rate Cycles: If interest rates increase, EMIs rise, which can strain monthly budgets.

• Frequent Changes: Some borrowers may find it stressful to track rate fluctuations or adjust to changing EMIs or tenure.

• Not Ideal for Short-Term Loans: In the short term, there may not be enough time to benefit from any potential rate drops.

When Should You Choose a Floating Interest Rate?

Floating rates may suit you if:

• You Expect Interest Rates to Fall: If you believe the RBI may cut rates in the future, floating rates can save money.

• You Plan to Prepay Early: With no prepayment penalty, floating-rate loans are flexible for early closure.

• You Have a Long-Term Loan: Over time, market ups and downs may balance out, making floating rates cost-effective.

• You Can Handle EMI Changes: If your income is stable or growing, you may manage rising EMIs better.

Things to Check Before Choosing a Floating Rate Loan

Before selecting a floating interest rate, consider the following:

• Benchmark Type: Check what benchmark your bank uses and how often it is revised.

• Margin Added: Understand how much spread the bank adds over the benchmark.

• Reset Frequency: Know how often the rate and EMI will be adjusted.

• Loan Tenure Impact: Changes in interest rate may affect EMI or increase your loan term.

• Total Interest Cost: Estimate how rate changes can affect your overall repayment.

• Prepayment Flexibility: Ensure there are no hidden charges for early payments.

Also, compare offers from multiple banks and read the terms carefully to avoid surprises.

Conclusion

Floating interest rates offer flexibility and the chance to save money when market rates fall. However, they come with uncertainty, and borrowers need to be financially prepared for changing EMIs. If you have a long-term outlook and are comfortable with a bit of risk, a floating rate can be a good option. Always evaluate your financial goals, income stability, and rate expectations before choosing the right loan structure.