Floating rate home loans are mortgages with variable interest rates that people can use to purchase or refinance residential property. The term "floating rate" is most commonly used in New Zealand and the United Kingdom while similar types of loans are usually referred to adjustable rate mortgages in the United States and elsewhere. Like conventional loans, floating rate home loans have term times that can last for 30 years or more.
Interest rates on floating rate home loans are fixed to an index such as the average yield on government bonds. The rate is set at certain margin to the index which means that the borrower's interest rate rises or falls in conjunction with changes in the index. Rates normally reset on either a monthly or an annual basis although some loans begin with a fixed rate term that lasts for five years or more after which rates change on an annual basis. Every time the rate changes, the lender recalculates the borrower's monthly payments so that the principal and interest will be paid off by the end of the loan term.
Some lenders offer floating rate home loans that result in the borrower having to make a balloon payment at the end of the loan term. With these products, the borrower makes monthly interest only payments but no principal payments are made during the loan term. After the final interest payment has been made the borrower must make a single lump sum principal payment.
Floating rate home loans typically become most popular when interest rates are declining. Borrowers in such lending environments do not like to lock in fixed rate loans when economic indicators suggest that rates will fall within the near future. Some people take advantage of falling rates and payments by making additional principal payments on their mortgages. In many instances, borrowers can greatly reduce the repayment term of a loan by making additional principal payments during the early years of the loan term.
While floating rate home loans are advantageous in falling rate environments, these loans are often problematic for people when interest rates begin to rise. Loan payments can theoretically double or triple as the result of interest rate hikes and borrowers sometimes lack the funds to cover their rising monthly debts. Since home loans are secured by residential liens, homeowners who fall behind on their loan payments stand to lose their homes to foreclosure. Due to this risk, critics of floating rate loans encourage borrowers to finance and refinance residential property with fixed rate mortgages.