What is a floating rate loan?
Variable interest
A floating rate is an interest rate which tracks a reference benchmark rate.
The interest rate payable on a floating rate loan is calculated as the benchmark rate plus a credit spread. The credit spread reflects the lender’s required return for its risk in lending money.
A borrower with a floating rate loan pays more when the benchmark rate is high and pays less when the benchmark rate is low.
Benchmark rates
Base Rate and SONIA
The official UK benchmark interest rates are Base Rate and SONIA.
Base Rate is the Bank of England Official Bank Rate as published by the Bank of England. Base Rate determines the interest rate paid to commercial banks that hold money with the Bank of England. Base Rate is the traditional reference benchmark rate for residential tracker mortgages.
SONIA (Sterling Overnight Index Average) is a benchmark interest rate administered by the Bank of England. SONIA is based on actual transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions. SONIA is used as the reference benchmark rate for commercial loans.
Historically, Base Rate and SONIA have tracked one another closely, although there is no guarantee that the two rates may not de-couple in the future.
Other floating rates
LIBOR and SVR
LIBOR
The London Interbank Offered Rate (LIBOR) was a benchmark interest rate at which banks made short term loans to one another. Scandals surrounding LIBOR and questions around its validity as a benchmark rate resulted in it being phased out and replaced by SONIA.
SVR
Standard variable rate (SVR) is the default interest rate a mortgage lender will charge a customer not having a fixed rate or tracker mortgage. SVR is not an official benchmark rate. Each lender sets its own SVR, which varies at the lender’s discretion and does not move automatically in line with changes to Base Rate.
What are the risks of floating rates?
No protection from rising rates
The risk for a floating rate borrower is that there is no upper limit on the interest rate they will have to pay.
The risk of higher interest payments may be controlled by applying an interest rate cap to the floating rate loan.