You may know a floating interest rate as an adjustable rate or ARM. When you have a floating rate, it doesn’t remain the same for the life of the term, as a fixed-rate does. An ARM changes according to its terms, typically on an annual basis.
Keep reading to learn how the floating interest rate works.
The Basics of the Floating Interest Rate
Your lender will quote you more than just an interest rate with a floating rate. You will hear the terms, index and margin too:
- Index – The number that your interest rate starts at, such as the Prime rate or LIBOR
- Margin – The percentage the lender adds to the index to come up with your rate
Let’s say your rate follows the 1-year Libor, which is 2.8% right now (this is hypothetical). If the lender says you have a 2% margin, your interest rate for that period would be 4.8% (index plus margin).
But, let’s confuse matters further – before your rate adjusts, your ARM has a fixed period or introductory period. The loan’s terms determine how long your fixed period lasts. For example, a 3/1 ARM has a 3-year fixed period and then adjusts one time a year afterward. A 5/1 ARM has a 5-year fixed period and then adjusts annually.
How Your Payment Changes
When you accept the loan, your lender will tell you the ‘change date.’ This is the date each year that your rate will change. You can’t predict what your rate will be on that date because no one has the ability to predict the market. Luckily, though, the law requires lenders to give you plenty of notice of the rate change. You can also watch the market yourself. If you see rates continuing to rise, you may want to consider refinancing out of the floating interest rate loan.
If it’s your first rate change, lenders must notify you 6-7 months in advance of the rate change. They must send you an estimated rate and payment so that you can make a decision before the change occurs. If your rate already changed at least once, the lender must give you 3-4 months advance notice.
The ARM Caps
Floating interest rates have caps, which is good news for you. You don’t have to worry about your rate going sky-high making your payment unaffordable. There are limits, but you have to be okay with those limits. Your floating interest rate will have the following caps:
- Initial adjustment cap – The maximum about your rate can change on the first adjustment date
- Periodic adjustment cap – The maximum amount your rate can change at each subsequent adjustment date
- Lifetime adjustment cap – The maximum amount your rate can change over the loan’s lifetime
The Benefits of a Floating Interest Rate
Floating interest rates have their benefits including:
- An initial low interest rate – ARM loans typically have a low introductory rate to entice borrowers to take it. If you have a long enough fixed term, such as five years, you could save a significant amount of money on interest.
- A low initial payment – A lower interest rate means a lower payment, which can make it easier to afford a home. If you are in a career that will provide you with a much higher income in the future, you can become a homeowner now and have the reassurance of affordability in the future.
Sometimes an ARM loan allows homebuyers to purchase a larger home because of the lower payment. It’s like a domino effect. If you have a lower payment, you have a lower debt ratio, which allows you to borrow more, should you need it.
The Downside of the Floating Interest Rate
As you probably guessed, floating interest rates have downsides.
- Unpredictable payments – Your payments will change after the introductory period. They may increase or they may decrease. Not knowing your payments in the future can be scary and put you in ‘payment shock.’
- Difficult to budget long-term – With rates change annually, you can’t budget your money, which makes it hard to plan for the long-term
Who Benefits from a Floating Interest Rate?
It can be a tossup deciding who should take a floating interest rate and who should stick with the fixed rate. Typically, the following borrowers benefit from the ARM:
- Short-term buyers – If you know you will be in a home for a short period, take advantage of the lower interest rate and save money on your interest charges
- Buyers in a successful career – If you are a doctor, lawyer, or are in any other profession where your income will increase significantly through the years, you can save money on interest now while having the ability to afford the higher payments in the future
- Buyers that need wiggle room – If your debt ratio is close to the maximum guidelines, you may benefit from a lower interest rate/lower payment, allowing you to buy the home
A floating interest rate can be beneficial, but you need to use caution. Look at the big picture and ask the lender a lot of questions about the terms of the loan. Knowing that your rate will change in the future is scary, but it can be beneficial if you use the loan to your advantage.