1. Floating rates
For the final lesson in the course, we'll be discussing floating interest rates - another common type of interest charged on loans.
2. What are floating rates?
On a floating rate loan, the interest rates are not fixed throughout the term of the loan.
Instead, the rates are based on a central bank index, such as the US Federal Reserve or the London Overnight rate, or LIBOR.
These prime rates are the rates that the bank borrow at.
As a consumer, you pay a premium on top of that rate.
These rates change frequently, with central banks meeting on a quarterly basis, but rates can change at any time.
To avoid having an interest rate which constantly changes, a loan can specify that rates only change on specific dates, such as once a year. These dates are referred to as reset dates.
3. Floating vs. fixed rates
As mentioned before, the interest rate on a floating rate loan can change throughout the course of a loan.
However, in most cases, the monthly payment on the loan also cannot change. There is one special case, which is when the interest exceeds the payment which we'll be discussing later.
When interest rates drop, the amortization period on the loan accelerates since more payment is being applied to the principal. The opposite is true when rates increase.
4. Rate reset example
In this example, there is a $500,000 15 year loan which is starting at 5%, amortizing monthly.
If the rate never changed, then the loan would amortize for 180 months, as expected.
However, if the rate increases to 5.25%, it will take 185 months to pay off the loan. Conversely, if it drops to 4.75%, it will take only 176 months to pay off the loan.
If the rate drops all the way to zero, then all payments would be applied to principal, and the loan would fully amortize in 127 months.
But what would happen if the rate was increased to 9.5%?
In this case, the time to pay off is infinite.
The loan will never get paid off.
How does this happen?
5. Negative amortization
When the interest rate rises so high that the payments fail to cover the interest, then a negative balance is paid to the principal.
This is added back to the opening balance, creating a higher closing balance.
If the payment is not increased, then the closing balance will never reach zero and eventually rise to infinity.
6. Maximum interest rate
The maximum interest rate is the highest possible rate on a loan before negative amortization.
This assumes that the payment was fixed at the beginning of the loan.
It can be calculated at any time on a loan, by taking the balance, dividing by the installment payment and multiplying by payment frequency to calculate an annual figure.
In our $500,000 at 5%, 15 year loan amortizing monthly example, dividing 500000 by our monthly installment of $3953.97 provides a 9.48952% annual rate.
7. Time for floating interest!
Now, it's time to do some practice on floating rates and maximum interest rates!