Floating-rate loan

For many entrepreneurs, access to financing is essential for growth and stability. When you borrow from a bank, a key choice will be whether to take a fixed-rate or a floating-rate (also known as variable-rate) loan. Understanding how these work, how they affect the interest rate you pay, and which is right for your business can help you protect your profitability.

What is a floating-rate loan?

When you take out a floating-rate loan, the interest rate will fluctuate over time—and as a result, so will your loan payments, assuming your loan is non-blended.

The interest on a floating-rate loan is tied to a base rate—such as a bank’s prime lending rate—plus or minus a margin. When central banks (like the Bank of Canada or the US Federal Reserve) adjust their monetary policy, or when supply and demand in the capital markets shift, that rate changes—and your loan payments change with it.

Suppose you borrow $100,000 and plan to repay it over five years. If you choose a fixed-rate loan with 6% interest, you will pay about $1,930 per month for the entire term, no matter what happens to interest rates. But with a floating rate, your payments could change:

• If the rate dropped to 5%, your monthly payment would fall to about $1,890.
• If the rate rose to 7%, your monthly payment would increase to about $1,980.

This example illustrates a key trade-off:

• By locking you into an interest rate, a fixed-rate loan buys you stability—but you sacrifice the opportunity to pay less if rates drop.
• By freeing you from a set interest rate, a floating-rate loan can save you money—but you may find yourself on the hook for higher payments if rates rise.

What are the advantages of a floating-rate loan?

Hands down, the main advantage of a floating-rate loan for a business is cost. Historically, these loans have tended to cost less over the long term than fixed-rate loans.

“If you looked at any 30-year period in history, on average, floating rates have tended to be the cheapest option, with the lowest interest rate,” says Nigel Robertson, Associate with BDC’s Growth and Transition Capital group. “The rate then usually edges slightly higher for a 1-year fixed term, then higher again for a 3-year term, then 5-year, and so on.”

This means you’re likely to pay less interest over the life of the loan, with the important caveat that this strategy can backfire if interest rates rise unexpectedly.

Another advantage: If you hope to pay off your loan early—by making prepayments—floating-rate loans usually have lower penalties than fixed-rate loans.

Do floating-rate loans allow prepayments?

Whether or not you can prepay your floating-rate loan depends on your bank. Some do not allow it, while others may allow you to prepay up to 10% a year. At BDC, you can typically prepay 15 to 20% of the outstanding principal each year without penalty. Other banks may also offer prepayment privileges, but the allowable amounts are generally less (around 10%) and there may be penalties.

Paying the loan down more aggressively than that—for example, 30 or 50% at once—is a different matter. Both floating- and fixed-rate loans will usually trigger penalties in that case—typically three months’ worth of interest on the remaining amount, although it can vary by lender. If you foresee wanting to do this, ask your lender about the penalty rules before you sign for the loan.

What are the disadvantages of a floating-rate loan?

The biggest downside of a floating-rate loan is uncertainty: Your loan costs will rise if interest rates go up, sometimes faster than you can react. For this reason, floating-rate loans can be risky for businesses with slim margins that can’t absorb sudden cost increases.

Despite the historic trend for floating-rate loans to be offered at lower interest rates, there have been periods where they were more expensive. In fact, this was the case for a while after the COVID-19 pandemic as central banks wrestled with inflation. Unforeseen economic events can also send interest rates sharply higher without warning.

Floating-rate borrowers also need to keep an eye on economic news and forecasts.

“With a floating-rate loan, you can’t just set it and forget it,” says Robertson. “You need to pay attention to what’s happening with interest rates.”

How can I choose between a floating-rate loan and a fixed-rate loan?

The choice between a floating and fixed-rate loan often centres on your business’s risk tolerance and cash flow stability.

If your revenues are fixed—for example, suppose you’re a landlord collecting monthly rents from a dozen commercial tenants—then a fixed-rate loan might make more sense because you would not be able to quickly generate additional income on short notice to offset a sudden rise in borrowing costs.

For businesses with healthy cash flows and a tolerance for fluctuations, a floating-rate loan can save money over time without adding too much stress.

Ultimately, weigh whether your business can withstand higher payments if rates rise. Will the prospect of an interest rate hike keep you up at night?

“It really comes down to your appetite for risk,” says Robertson. “Can your business handle the higher payments if rates suddenly spike?”

Can I switch from a floating-rate loan to a fixed-rate loan, and vice versa?

That depends on your loan contract and bank, says Robertson—but even if the fine print permits it, you’re likely going to be better off sticking with your first choice.

A move from a floating-rate to a fixed-rate loan will generally incur a loan amendment fee because the bank will want to cover its administration costs.

A move in the other direction will usually cost even more (and be harder to do) because your bank will want to charge a penalty to cover some of the interest revenue they now stand to lose.

In practice, switching is possible but costly, so it’s best to choose carefully and plan to stick with your decision.

What is the base rate for a floating-rate loan?

Each bank sets a base rate to which your floating-rate loan is tied. Most chartered banks in Canada use the prime lending rate, which moves in lockstep across institutions when the Bank of Canada changes its overnight rate. At BDC, we refer to it as the base rate.

Either way, your floating-rate loan is priced using that rate—for example, prime plus 0.25% at a charter bank or base minus 1.25% at BDC. Depending on market conditions, the offer could also be prime or base minus a percentage.

“Think of the prime rate as the anchor: your floating-rate loan moves up or down with prime, plus or minus a margin your bank sets,” says Robertson.

Fixed-rate loans are priced differently, so the prime or base rate does not directly affect them.

How do I calculate the effective interest rate for a floating-rate loan?

Banks will quote you a nominal annual interest rate (usually the base rate plus a margin), but if the interest is compounded during the year, the true rate will be higher.

Some lenders compound semi-annually, others monthly, and some calculate interest without compounding. The more frequently interest is compounded, the greater your interest cost will be. The effective annual rate (EAR) tells you the true cost of borrowing with compounding factored in.

For example, a loan quoted at 8% with semi-annual compounding is effectively 8.15% annually, while the same loan with monthly compounding is effectively 8.3% annually. Small differences in compounding can add up to tens of thousands of dollars over the life of a large loan, so it’s worth clarifying how your loan’s interest is calculated.

Most BDC loans are non-blended and not compounded. However, we do compound monthly on blended loans.

Essentially, the EAR is calculated as your nominal rate divided by the number of compounding periods, plus 1, raised to the power of the number of compounding periods, minus 1. The formula looks like this:

So, with a nominal rate of 8% and monthly compounding:

Most spreadsheet programs (like Excel or Google Sheets) have a built-in function that can calculate EAR for you.

All this said, with a floating-rate loan, the nominal rate itself changes whenever the base rate changes. That means the EAR can only be calculated as a snapshot in time. As interest rates move up or down, your EAR will shift too—so the true cost of the loan isn’t fixed, but evolves over the life of the loan.

Where can I get advice on floating-rate loans?

No one can predict where interest rates will go—and banks will be reluctant to advise you because they don’t want the blame if you later feel you made the wrong choice. While your bank can explain the terms of the loan, your accountant is better placed to help you decide what’s best for your business.

“No one has a crystal ball on interest rates,” says Robertson. “It’s best to get advice from someone who knows your business inside and out.”

You can also run “what if” scenarios—using a spreadsheet or other tools from your bank—to test how your payments would change if rates went up or down. This can help you decide whether you have the appetite for the risk that comes with floating-rate loans.

Next step

Read more about whether a fixed-rate or variable-rate loan is best for your business.