Interest Rate Floor: Definition And How It Works

You may already be familiar with loan products that have a variable rate, which means that the interest rate is not fixed – it adjusts periodically. An interest rate floor refers to the lowest interest rate that these variable rates can possibly go. An interest rate floor helps investors who buy derivatives so they’ll know that their rate of return will never fall below a specific benchmark. Derivatives are financial contracts that derive their value from an underlying asset or benchmark.

If you take out an adjustable-rate mortgage (ARM) as a borrower, an interest rate floor will protect your lender from interest rates adjusting below a preset level and therefore causing them to lose money on the loan.

In this article, we'll go over the interest rate floor definition and how it affects both borrowers and lenders.

What Is An Interest Rate Floor?

An interest rate floor relates to a floating rate loan product and protects the lender in derivative contracts and loan agreements. The opposite of an interest rate floor is an interest rate ceiling, also called a rate cap.

The Difference Between Interest Rate Floor And Interest Rate Cap

Now that we've defined an interest rate floor, what is an interest rate cap, in contrast?

Let's say you have a 7/6 ARM. Several factors impact 7/6 ARM rates, including the index it's attached to, the margin, interest rate floors and caps as well as intervals. In this example, the first number, 7, tells you how long your initial interest rate lasts (7 years). The second number, 6, tells you how often the rate will change after that (every 6 months).

When you get an adjustable-rate mortgage (ARM), several kinds of caps control how much your interest rate can adjust, including the initial adjustment cap, subsequent adjustment cap and lifetime adjustment cap.

The initial adjustment cap limits how much the interest rate can increase the first time after your fixed-rate period expires.

The subsequent adjustment cap explains how much your interest rate can adjust after that. It cannot go over a specific number of percentage points compared to your previous rate.

Finally, the lifetime adjustment cap shows how much your rate can increase in total over the life of your loan. This cap varies depending on your lender.

Your loan estimate, a 3-page form you receive after you apply for a loan and which outlines your loan details, will include an adjustable interest rate (AIR) table, which details the change frequency and limits on interest rate changes for your specific loan.

To sum up, the interest rate floor protects the lender, and the interest rate cap protects you, the borrower.

How Does An Interest Rate Floor Work?

As we've mentioned, interest rate floors are worked into loan agreements to reduce the risk to a lender of losing money on the loan. You can see the interest rate floor provision written into your contract listed among the lender's terms.

In the case of a derivative contract, the interest rate floor also refers to an agreement between a lender and investor that a variable rate will never fall below a certain percentage. It can help investors understand their limits, protecting them against declining rates and lost income.

Interest Rate Floor Example

Let's say that you have a 5/1 ARM, which holds a fixed interest rate for the first 5 years of your mortgage. Afterward, your 5/1 ARM will switch to an adjustable interest rate (a floating rate) for the rest of your loan term. Let's also say that your lending contract says that your loan has an interest rate floor of 3%. In other words, no matter what happens, your interest rate will never fall below 3%.

Let's walk through another example. Let's say that you're a lender underwriting a loan for a client. Let's say the client opts for a variable rate loan. You may hedge the loan by buying an interest rate floor option to protect against falling interest rates which could sink below the interest rate floor.

Zero Floor Interest Rate Example

Zero floor interest rates may seem like a good thing, but can actually end up being the opposite. When zero-based floors are implemented into floating-rate loan agreements, it means that the base rate is negative, or zero. This means that if you're the borrower, you'll pay at least the margin but do not qualify for a deduction even in a negative rate environment. In short, as the borrower, you'll probably never benefit from a zero-floor interest rate environment.

The Bottom Line: A Floor Rate On A Loan Is Settled Between Two Parties

To put it simply in the context of an ARM, an interest rate floor puts a limit on how low an interest rate can go. Interest rate floors protect the lender while interest rate caps protect the borrower.

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