What Is a Floating Rate Loan?

Geri Terzo

Borrowers may be presented with different types of debt obligations to choose from. One such option could be a floating rate loan, which is a type of financing in which the repayment terms change. The financial obligation of a borrower generally includes some monthly repayment amount. On a loan with floating terms, however, the interest rate that is attached to the payments varies based on the market rates over a given period of time. The market rate from which a floating rate loan is generally based is usually set by monetary policy makers in a given region.

Floating rate loans may be used for a second mortgage.
Floating rate loans may be used for a second mortgage.

An individual or organization might seek to obtain a floating rate loan for different reasons. For instance, the debt might be incurred so that a person or business can obtain a mortgage to acquire a piece of property. Another purpose for a floating rate loan could be to secure a second mortgage on real estate so that the owner of real estate can afford upgrades and improvements that are necessary. As a result of the refinancing, the terms of a mortgage may be adjusted to a floating rate loan.

Repayment terms may change during a floating rate bank loan.
Repayment terms may change during a floating rate bank loan.

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Individual and corporate borrowers may benefit from loans with floating rates under certain economic conditions. When market interest rates are expected to decline over a period of time, for instance, the cost for borrowing money becomes more attractive. A loan with a floating rate attached will typically remain compelling as long as the monthly obligation decreases or remains low. Once economic conditions shift and the low-rate environment may not persist, the borrower is likely to face higher costs. When it appears that rates have neared some bottom and after a floating-rate product has been owned for a minimum period, a borrower may be able to refinance a loan using a fixed percentage to secure lower repayment terms.

Investors can gain exposure to a floating rate loan by allocating money to an investment management firm that purchases these debt contracts. Asset management firms can acquire the floating rate loans that banks extend to businesses and create investment portfolios for clients with these products. In exchange, the money managers are paid a set return known as a premium. This steady yield is in addition to another income based on regional short-term interest rates, which become subject to periodic changes. Throughout an environment where rates are on the rise, money management firms are able to earn enhanced profits and pass those returns on to investors.

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