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What Is a Floating Interest Rate?

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TERMINOLOGY

Many different types of loans have a floating interest rate attached to them. Here are the basics of what a floating interest rate is and how it works.

Floating Interest Rate

A floating interest rate is an interest rate that is allowed to fluctuate from one period to the next. When you agree to this type of loan, it is typically so that you can save money with a low interest rate over the first portion of the loan. However, this type of loan can be very risky because you do not have any control over what your payment is going to be in the future.

How It Works

To determine what the interest rate is on a floating-interest-rate loan, the lender is going to use a financial index. Your interest rate is going to be tied to the performance of a financial index. If this index increases, your interest rate is also going to increase. If the index decreases, your interest rate is actually going to go down.

Caps

Most of the time, you are going to have some type of protection as far as how much your interest rate can increase. These interest rate caps will limit the amount of increase over a year or over the life of the loan.