Interest rates on bond investments and loans can be fixed, which never change, or floating. Whether one is better than the other depends on the specific situation. Unfortunately, it also requires a crystal ball. Investors and borrowers who choose the uncertainty of a floating rate may benefit from changes in the market, or they might not. It is impossible to predict how things will turn out.
Floating-Rate Securities Basics
Floating-rate securities, also known as floaters, pay interest that resets periodically. Generally, they come in the form of taxable, corporate bonds. Floating interest rates are based on different rate indexes, like the Federal Funds Rate, the Prime Rate or the British LIBOR. The yield might be higher than the index rate, or it might be lower. Rates reset daily, weekly, monthly, quarterly, semiannually or annually depending on the individual security. Interest usually does not compound.
Advantages and Disadvantages of Floating-Rates Securities
When interest rates are very low, you might want to take advantage of floating-rate investments so that you’re not locked into a really low rate when interest rates rise. Of course the flip side is that if rates decline, you’ve missed out on the opportunity to secure a higher rate. When interest rates rise, the resale value of lower-rate fixed bonds consequently declines. Floating-rate products act as a buffer against this risk. They do, however, have risks of their own. Many floating-rate funds have low credit ratings and are considered to have some possibility of default. You also can’t rely on any payments from floating-rate bonds since you never really know what interest rates will be.
Floating-Rate Mortgage Basics
Whether you want to call them floating-rate, variable-rate or adjustable-rate mortgages (ARMs), the terms all mean the same thing. They are loans that come with interest rates that change periodically. Interest rates are fixed for a certain time period — typically five or seven years — and thereafter readjust, often annually. If you decide to get an adjustable mortgage, make sure to read all the fine print because many loans can adjust upwards with no cap on their interest rates. Home equity lines of credit (HELOCs) have floating interest rates while home equity loans usually have fixed rates.
Advantages and Disadvantages of Floating-Rate Mortgages
Floating-rate mortgages often have lower rates than fixed rate products, a fact that makes them ideal for loans that can be repaid quickly. The danger is that when rates adjust, they might adjust to a higher rate. There’s no way of knowing where rates will go in a year, let alone in five years, so borrowers run the risk of increased rates. Borrowers could also luck out if rates decrease and their loans adjust to a lower rate.
- SIFMA: Floating-Rate Securities
- Financial Planning Association: Managing Interest Rate Risk with Floating Rate Funds
- Motley Fool: Float Your Bond Boat
- Freddie Mac: Fixed-Rate Mortgage Overview
- The Federal Reserve Board: Consumer Handbook on Adjustable Rate Mortgages
- Bankrate.com: Even Now, HELOC Can Be Best Choice
- Jupiterimages/Photos.com/Getty Images