What Is an Interest Rate Floor?
An interest rate floor is an agreed upon rate in the lower range of rates associated with a floating rate loan product. Interest rate floors are utilized in derivative contracts and loan agreements. This is in contrast to an interest rate ceiling (or cap).
Interest rate floors are often used in the adjustable rate mortgage (ARM) market. Often, this minimum is designed to cover any costs associated with processing and servicing the loan. An interest rate floor is often present through the issuing of an ARM, as it prevents interest rates from adjusting below a preset level.
Interest Rate Floors Explained
Interest rate floors and interest rate caps are levels used by varying market participants to hedge risks associated with floating rate loan products. In both products, the buyer of the contract seeks to obtain a payout based on a negotiated rate. In the case of an interest rate floor, the buyer of an interest rate floor contract seeks compensation when the floating rate falls below the contract’s floor. This buyer is buying protection from lost interest income paid by the borrower when the floating rate falls.
Interest rate floor contracts are one of three common interest rate derivative contracts, the other two being interest rate caps and interest rate swaps. Interest rate floor contracts and interest rate cap contracts are derivative products typically bought on market exchanges similar to put and call options. Interest rate swaps require two separate entities to agree on the swapping of an asset, typically involving the exchanging of fixed-rate debt for floating rate debt. Interest rate floor and interest rate cap contracts can provide a different alternative to the exchanging of balance sheet assets in an interest rate swap.
Real World Example of an Interest Rate Floor
As a hypothetical example, assume that a lender is securing a floating rate loan and is looking for protection against lost income that would arise if interest rates were to decline. Suppose the lender buys an interest rate floor contract with an interest rate floor of 8%. The floating rate on the $1 million negotiated loan then falls to 7%. The interest rate floor derivative contract purchased by the lender results in a payout of $10,000 = (($1 million *.08) - ($1 million*.07)).
The payout to the holder of the contract is also adjusted based on days to maturity or days to reset which is determined by the details of the contract.
The Use of Floors in Adjustable Rate Loan Contracts
An interest rate floor can also be an agreed upon rate in an adjustable rate loan contract, such as an adjustable mortgage. The lender’s lending terms structure the contract with an interest rate floor provision, which means that the rate is adjustable based on the agreed-upon market rate until it reaches the interest rate floor. A loan with an interest rate floor provision has a minimum rate that must be paid by the borrower to protect the income for the lender.