Floating Interest Rate: An Overview
A floating interest rate, also known as a variable rate, refers to a loan pricing mechanism where the interest rate fluctuates over the borrowing term. This fluctuation occurs because the interest rate is tied to an underlying index.
Understanding Floating Interest Rates
A floating interest rate is contingent on an underlying benchmark and is expressed as a percentage of the outstanding loan amount. Unlike fixed interest rates, which remain constant throughout the borrowing period, floating interest rates change based on prevailing economic conditions.
Calculating Floating Interest Rates
The interest rate pricing of debt with floating interest rates is typically expressed in two parts:
- Base Rate (e.g., LIBOR)
- Spread
Floating Interest Rate Formula
Floating Interest Rate (%) = Base Rate + Spread
This formula calculates the interest expense on securities priced on a variable basis. Generally, floating interest rates are associated with senior debt, whereas fixed interest rates are more common with bonds and riskier debt securities.
LIBOR Debt Pricing Example
Historically, the London Inter-Bank Offered Rate (LIBOR) has been the standard benchmark for borrowings. LIBOR is the rate at which financial institutions lend to one another for overnight, short-term loans.
Example Calculation
Let's assume LIBOR is currently at 150 basis points, and a senior loan’s interest rate is “LIBOR + 400”.
Interest Rate=(10,000150)+(10,000400)=1.5%+4.0%=5.5%
Floating Interest Rate vs. Fixed Interest Rate
A fixed interest rate remains constant during the entire lending period and is independent of any market-based benchmark. In contrast, a floating interest rate moves up and down based on the movements of the underlying index (e.g., LIBOR, SOFR).
Falling Market Rate → Beneficial for the borrower (lower interest rate)
Rising Market Rate → Not beneficial for the borrower (higher interest rate)
Floating interest rates pose more risk to both parties due to potentially unpredictable changes in the benchmark. To protect the lender, an interest rate "floor" is typically included to ensure a minimum yield is received. The greater between the benchmark rate and floor rate is selected:
Floating Interest Rate=MAX(Benchmark Rate,Floor Rate)
Floating Interest Rate Calculation Example
Assume a term loan with an outstanding balance of $50 million, with neither mandatory amortization nor a cash sweep, so the balance remains constant. The spread is added to the LIBOR each year, as shown below.
Interest Rate=LIBOR+Spread
Using the "MAX" function in Excel ensures the LIBOR value used does not dip below the interest rate floor of 1.5%. Hence, the interest rate is 5.5% for the first two years (spread + the minimum floor), but when LIBOR exceeds 150 basis points, the rate increases to 5.8% and 6.0% in subsequent years. LIBOR and the pricing are denoted in basis points, so each figure is divided by 10,000 to convert to a percentage.
Multiplying the interest rate by the average of the beginning and ending balance of the term loan results in the interest expense charged in each period, increasing from $2.8 million to $3.0 million over the projection period due to the increase in LIBOR.
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