What Is an Interest Rate Floor?

Definition and Examples of an Interest Rate Floor

An interest rate floor is the lowest possible rate a lending product can fall to over the life of the loan. Setting an interest rate floor reduces the level of risk to the bank or lender receiving interest payments. This is because if the rate falls below a certain point, the lender would lose money on the cost of lending and servicing the loan.

An interest rate floor is often used in variable-rate loan products, like an ARM. An ARM comes with a certain level of unpredictability to both the borrower and the lender because the rates will change over time. An ARM differs from a fixed-rate mortgage, which has the same interest rate for the life of the loan.

Let’s look at an example. For instance, if you took out a 5/1 ARM, that means you will have a fixed interest rate for the first five years. After that, your interest rate will adjust every year depending on the market conditions.

If your rate fell below a certain point, your lender could end up losing money on the loan, which is why ARMs come with an interest rate floor. Your lending contract might state that your loan has an interest rate floor of 3.5%. This means that no matter what happens in the market, your interest rate will never fall below 3.5%. This minimum rate protects the lender from experiencing a significant decrease in profits or from losing money altogether.

How Does an Interest Rate Floor Work?

When a lender is underwriting a variable-rate loan for a borrower, they know the interest rate will go up and down over the life of the loan. An interest rate floor is an agreement between the borrower and lender that a variable interest rate will never fall below a certain point. This minimizes the lender’s risk on variable loan products and keeps them from losing money on the loan.

An interest rate floor is also frequently used in a derivative contract, where a buyer receives payments at the end of each period.

In this case, the interest rate floor is considered an agreement between the bank and the investor that a variable rate will never fall below a certain point. It can help investors understand their downside limit and determine how much risk they’re comfortable taking on. In this scenario, the interest rate floor protects the investor against declining rates and lost income.

Interest Rate Floor vs. Interest Rate Ceiling

As mentioned, when you take out a variable-rate loan product, the interest rate floor is the lowest rate you’ll pay over the life of the loan. In comparison, the interest rate cap is the maximum rate you’ll pay on that loan.

After all, if your interest rate fell to 0%, then the lender has no incentive to do business with you. And as a borrower, it’s helpful to know that while your interest rate will adjust periodically, it will never go beyond a certain range.

If you’re interested in taking out an ARM, it’s important to compare offers from different lenders and pay particular attention to the interest rate cap. That’s because two different lenders can offer the same initial interest rate but have different interest rate caps.