Interest rate floor: Definition and how it works

If you have an adjustable-rate mortgage (ARM) or are thinking about applying for one, it’s normal to wonder about how exactly the interest rate of the loan is set after the introductory rate. You may have heard the term interest rate floor used and wonder what that means or how it differs from an interest rate cap.

A rate floor, as well as a rate cap, places limits on how much an ARM’s interest rate can change, setting a minimum or maximum rate for the loan. We’ll break down how a rate floor works and what you need to know.

What is an interest rate floor?

An interest rate floor is the lowest interest rate that your adjustable-rate mortgage can have once its rate begins to adjust. This sets the minimum rate you can expect to pay over the life of the loan.

Typically, variable-rate loans have rates that are set to be equal to an index rate, plus a margin rate. For example, you might get a loan with a rate equal to the 10-year bond rate plus 2%. If, at the time of a rate adjustment, the 10-year bond rate was 3.25%, your loan’s new rate would be 5.25% (3.25 + 2).

A rate floor places a limit on how low the loan’s rate can drop. If, in the above example, the loan had a rate floor of 5.5%, your ARM would adjust to have a 5.5% interest rate despite the formula stating the rate should be 5.25% because the rate cannot go lower than the floor.

Lenders use rate floors to ensure a certain minimum rate of return from their loans.

Interest rate floor vs. interest rate cap

An interest rate floor is similar to an interest rate cap, placing a limitation on how much an adjustable-rate mortgage’s interest rate can adjust. Lenders use them to set a minimum rate of return they can earn from a loan.

Interest rate caps, on the other hand, set a maximum amount by which the loan’s rate can adjust, protecting the borrower from exceedingly high rates.

There are a few different types of rate caps you need to consider:

• Initial adjustment cap: After the initial rate expires, this cap limits how high (or low) the rate can adjust.
• Subsequent adjustment rate cap: This cap limits the adjustment amount each period during the life of the loan (after the initial adjustment cap). The cap applies to the amount of increase or decrease in the loan.
• Lifetime adjustment cap: This is the cap that limits how high the interest rate can rise during the life of the loan. This cap varies; however, if the lifetime cap is 12%, your loan’s interest rate is limited to this rate ceiling.

When you get your loan estimate, your lender will outline any rate floor or cap that will apply to your loan.

How does an interest rate floor work with an adjustable-rate mortgage?

With an ARM, interest rate floors serve to protect the lender, placing a limit on how far your loan’s interest rate can drop. Put another way, it determines the minimum return the lender will earn from the loan in the form of interest.

Interest rate floors are a drawback for borrowers, preventing the rate of their loan from falling too far, which would mean paying less interest over the life of their loan. That’s why it’s essential to pay attention to rate floors and caps in your loan estimate paperwork.

Interest rate floor examples

These examples illustrate how rate floors affect borrowers and lenders.

Interest rate floor example for borrowers

When you get an ARM, it comes with an introductory rate that lasts for a few years, and then it adjusts. For example, a 5/1 ARM would have an introductory rate for five years, with rate adjustments annually after that. For some buyers, a floating interest rate meets their goals if they don’t plan to stay in a home for a long time and want a lower interest rate.

In some cases, the intro rate may be the rate floor, while in others, the rate floor for adjustments could be lower (or even higher) than the intro rate.

Imagine you get a 5/1 ARM with an introductory rate of 5.75%. The loan’s paperwork states that at each adjustment, the rate will be set to the LIBOR rate plus a 2% index, with a rate floor of 5.5% and a rate cap of 12%, and an adjustment cap of 2%.

At the first adjustment, the LIBOR rate is 3%. According to the loan’s formula, the new rate should be 5%, but the rate floor is higher, forcing the rate to fall to just 5.5% and no lower. That means you’ll pay more interest than you would if the loan did not have a rate floor.

Interest rate floor example for lenders

From the lender’s point of view, the rate floor is a benefit, ensuring a certain minimum return from a loan. Using the above example, the lender can ensure that it will see a return of no less than 5.5%, assuming the borrower doesn’t default, because the rate floor keeps the loan’s rate at that level or higher.

Zero-floor interest rate example

In some cases, an ARM may have what is called a zero-rate floor.

This name is a bit counterintuitive because it does not mean that the borrower will pay no interest. Instead, it means that the rate cannot go below the margin rate. If the index’s interest rate falls below 0%, it is effectively ignored for calculating the ARM’s new rate.

For example, if an ARM’s rate is equal to the ten-year bond rate plus 2% and the ten-year bond rate goes negative, such as to -0.5%, the loan would still charge 2% interest.

This again serves to protect the lender rather than benefit the borrower, preventing the borrower from seeing the maximum amount of savings on interest from falling rates.

The bottom line: Understanding the interest rate floor is useful

Most adjustable-rate mortgages come with an interest rate floor, setting the absolute minimum rate that the loan can have once its rate begins to adjust. These rate floors can benefit lenders and may be a drawback for borrowers, ensuring that the loan’s rate cannot fall too far, even if market rates decrease sharply.

Check your loan estimate for a rate floor and make sure that you understand how it can limit your potential savings should rates fall during the life of your ARM.

If you’re ready to apply for a mortgage, you can reach out to Rocket Mortgage today.