Interest Rate Floor: Definition And How It Works

Certain loan products have a variable rate, which means the interest rate isn’t fixed but adjusts periodically. Loans with a variable rate come with several features built in to help manage and stabilize interest rates – and one of those features is what’s known as an interest rate floor.

Understanding what an interest rate floor is and how it affects both borrowers and lenders is critical for anyone thinking of taking out a loan with a variable interest rate.

What Is An Interest Rate Floor?

An interest rate floor refers to the lowest interest rate that a variable-rate loan can possibly hit. Also known as a floor rate, an interest rate floor is beneficial to lenders because lenders know the interest rate for a loan will never fall below a particular threshold even if market rates do.

An interest rate floor is also beneficial for investors who buy derivatives – financial contracts that get their value from an underlying interest rate – because it keeps their rate of return from dropping below a certain amount.

Interest Rate Floor Vs. Interest Rate Cap

While the interest rate floor protects the lender, the interest rate cap provides protection for you as the borrower by keeping the interest rate from rising above a particular point.

With an adjustable-rate mortgage (ARM), several types of caps control how much your interest rate can adjust:

• Initial adjustment cap: This limits how much the interest rate can rise the first time after your fixed-rate period expires.
• Subsequent adjustment cap: This is how much your interest rate can go up after an initial rate increase. It can’t jump by more than a specific number of percentage points relative to your previous rate.
• Lifetime adjustment cap: This is how much your rate can increase over the life of your loan. The lifetime adjustment cap will vary from lender to lender.

Your Loan Estimate, a three-page form you receive after applying for a loan, outlines your loan details. It will include an adjustable interest rate table, which details the change frequency and limits on interest rate changes for your specific loan.

How Does An Interest Rate Floor Work?

An interest rate floor is worked into a loan agreement to reduce a lender’s risk of losing money on the loan. You can find the interest rate floor provision in your contract among the other conditions of the loan.

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.

How Does An Interest Rate Floor Work With An Adjustable-Rate Mortgage?

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

When you take out an ARM with an interest rate floor, the floor rate will be specified in your mortgage contract. As the borrower, you can expect your interest rate to be the floor rate or higher for the life of your loan.

Interest Rate Floor Examples

It’s important to understand the concept of interest rate floors, from the perspective of both a borrower and a lender.

Interest Rate Floor Example For Borrowers

For the sake of an example, suppose 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 repayment term. Now suppose your lending contract says your loan has an interest rate floor of 3%. This means that, no matter what happens, your interest rate will never fall below 3%.

Interest Rate Floor Example For Lenders

For the purpose of this next example, you’re a lender underwriting a loan for a client that opts for a variable-rate loan. You may hedge the loan by buying an interest rate floor option to protect yourself against falling interest rates, which could sink below the interest rate floor.

Zero-Floor Interest Rate Example

As desirable as a zero-floor interest rate may seem on the surface, it might not be nearly as wonderful as you expected. When a zero-based floor is included in a floating-rate loan agreement, it means the base rate is negative, or zero.

If you’re the borrower, you’ll pay at least the margin but 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: Understanding The Interest Rate Floor Is Useful

To put it simply in the context of an ARM, an interest rate floor limits how low an interest rate can go. An interest rate floor serves the purposes of the lender while the interest rate cap is to the borrower’s benefit. Knowing exactly what an interest rate floor is and how it works can help ensure you make fully informed decisions as a home buyer.

Considering an ARM for your home loan? Apply for initial mortgage approval online with Rocket Mortgage^® to see your options.