Floating Interest Rate: Definition, How It Works, and Examples

A floating (or variable) interest rate is one that changes periodically in line with market conditions or a designated benchmark. Unlike a fixed rate, which stays the same for the agreed term, a floating rate rises or falls as the underlying index moves. Common products with floating rates include many credit cards and adjustable-rate mortgages (ARMs).

Key takeaways

• Floating rates fluctuate with a benchmark or market conditions; fixed rates do not.
• Floating rates are typically expressed as a benchmark rate plus a spread (margin).
• Common benchmarks include SOFR, the federal funds rate, and the prime rate.
• Floating rates can lower initial costs but increase uncertainty and budgeting risk if rates rise.

How floating rates work

Lenders tie a floating rate to a benchmark index and add a spread to determine the borrower’s rate. For example, a lender might charge “SOFR + 3%” (300 basis points). When the benchmark changes, the loan rate resets according to a preset schedule (quarterly, semiannually, annually, etc.). The spread reflects factors such as product type and the borrower’s creditworthiness.

Common benchmarks

• SOFR (Secured Overnight Financing Rate)
• Federal funds rate
• Prime rate (used frequently for credit cards)
• Mortgage-specific indexes such as COFI or the Monthly Treasury Average (MTA)

Types of floating-rate products

• Adjustable-rate mortgages (ARMs): Rates are set by an index plus a margin. Example: a 2% margin over SOFR means the mortgage rate = SOFR + 2%.
• Credit cards: Most have variable APRs tied to the prime rate; issuers add a margin based on the card and the cardholder’s credit profile.

Floating vs. fixed rates

• Fixed rate: constant interest rate for the applicable term, predictable monthly payments.
• Floating rate: starts at a rate that can later increase or decrease, changing monthly payments and overall interest cost.

Example: A 30-year fixed mortgage at 4% keeps the same monthly payment for the life of the loan. A variable-rate mortgage might start at 4% but adjust later, raising or lowering payments.

Illustrative example

A couple takes a $500,000, 30-year 7/1 ARM with an initial rate of 2% for seven years. After year seven the rate becomes floating and resets annually, tracking SOFR:
* Year 8: rate rises to 4%
Year 9: rate falls to 3.7%
Year 10: rate falls to 3.5%
Their interest costs and monthly payments change each reset until they refinance or pay off the loan.

Advantages

• Lower introductory rates than many fixed-rate loans, which can mean lower initial monthly payments.
• Can be attractive if you plan to sell or refinance before rate adjustments or if you expect rates to fall.

Disadvantages

• Payments and total interest can rise if market rates increase, complicating budgeting.
• Greater long-term cost uncertainty—borrowers effectively accept market risk.
• When rates are very low, a floating-rate loan can be especially risky because rates are more likely to rise.

How to decide

Consider:
* Your time horizon (will you sell or refinance before adjustments?)
Tolerance for payment volatility and ability to handle higher payments if rates rise
Expectations about future interest-rate trends
* Credit profile (which affects the spread) and potential refinancing options

FAQ

Q: Do credit cards have floating rates?
A: Yes. Most credit cards use the prime rate plus a margin determined by the issuer and the cardholder’s credit history.

Q: What does a floating-rate quote look like?
A: It’s usually shown as “benchmark + margin.” Example: if the rate is SOFR + 6% and SOFR is 6%, the effective rate is 12%.

Bottom line

Floating interest rates adjust with a benchmark and can lower initial borrowing costs, but they introduce uncertainty and the risk of higher payments if market rates rise. Choose a floating or fixed rate based on your financial goals, risk tolerance, and how long you expect to hold the debt.