What is an interest rate floor?

Example of an interest rate floor

You now know what a floor rate means. But the concept can be a bit fuzzy until you see an example. The best way to learn about an interest rate floor is to see how this financial detail would work in real life. Let’s take a closer look at two different examples.

ARM Interest Rate Floor

Let’s say you compare rates with different lenders and decide to go with a 5/1 ARM. When you take out a variable rate loan with this structure, the interest rate will remain the same for the first 5 years of your loan. After that, the ARM will adjust your interest rate for the duration of the term.

When you take out the loan, you agree to an interest rate floor of 5%. As you approach the 5-year mark, you discover that interest rates are hovering around 4%. But since you accepted the 5% floor, you will never see your rate drop below 5%.

Ultimately, the interest rate floor means you won’t save as much as you could when interest rates fall. But when accompanied by an interest rate cap, these guarantees can help prevent your mortgage payment from going over budget.

Interest rate floor on loans

Now let’s look at this from the lender’s perspective. As a lender, you structure an ARM with a mortgage customer. The home buyer wants an ARM 5/1.

Based on today’s economic conditions, you might decide that lower rates are a possibility. Since you don’t want to lose money on the loan, you stipulate a floor rate of 5% in the contract. If the benchmark interest rate falls below 5%, you can still charge the customer 5% interest on their loan.

Generally, lenders are very interested in including an interest rate floor. The goal is to protect their investment from losing money if market interest rates drop too much.

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