Floating interest rate can be defined as an interest rate that is not constant and it changes from time to time.
How Floating Interest Rate Works
Let’s assume that a person ABC wants to start a business and borrows a loan of $5,000 from a company XYZ. The company XYZ offers you a floating interest rate loan where the interest rate is at prime 5 percent plus. This means that if the prime rate is 4 percent than an additional 5 percent will be added to it in order to make the loan equals to 9 percent. The rate of the interest will reset from time to time as the prime rate changes. This means that if the prime rate set by the bank goes up your interest rate will also go up as well as if the prime rate goes down your interest rate will also go down. This fact helps bank to avoid losing money even if the prime rate goes up after issuing loan to individual or business entities. This is also helpful for the borrower as it helps in paying less interest on the loan if the prime rate goes down hence it helps you from avoiding paying more.
Importance of Floating Interest rate
One thing must be made clear that interest does not change by itself. There are certain triggers that change the interest rate within the market. These triggers can be the economic indicators for example the economic information about the financial status of the individual or the business in question. Interest rate is important because these are the most powerful and the most influential indicators of the economy of the certain market. This is the reason most of the banks and financial institutions take interest in implementing floating interest rate structure
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