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Sometimes referred to as a variable, or an adjustable-rate is a form of interest rate that changes periodically. The interest rate may increase or decrease depending on market conditions. Generally, it is linked to a reference rate which is a benchmark of financial factors. This is opposed to a fixed interest rate which remains unchanged throughout the term.
Typically it is linked to LIBOR, the Federal Funds Rate, or the prime rate. LIBOR is the London Interbank Offered Rate. The Federal Funds Rate is a target rate set by the US government’s Federal Open Market Committee. Prime Rate refers to the interest rate banks charge their highest credited corporate customers.
Floating interest rates are commonly associated with mortgages, especially Adjustable Rate Mortgages (ARMs). They are also commonly used by credit card companies and other lenders.
In some cases, floating rates cost less than fixed rates, although the borrower takes the risk that rates will rise in the future.
Example
The rate for debt is generally referred to as a spread or margin. For example with mortgages, a 10-year mortgage may be priced at 6-month prime +2%. This means that at the end of every 6 month period the rate will be recalculated based on the prime rate and the percentage agreed upon. In relation to mortgages, some special features are added at times, such as an interest rate cap, which limits the volatility.
Floating interest rates may be more suitable for a short-term loan as opposed to a long-term loan, although this depends on its terms and conditions.