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.

BREAKING DOWN 'Interest Rate Floor'

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.

For 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.

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.

Use in Adjustable Rate Loan Contracts

An interest rate floor can also be an agreed upon rate in an adjustable rate loan contract. 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.

RELATED TERMS
  1. Floor

    A floor may refer to: (1) the lowest acceptable limit by controlling ...
  2. Interest Rate Collar

    An interest rate collar is an investment strategy that uses derivatives ...
  3. Initial Interest Rate

    Initial interest rate is the introductory rate on an adjustable ...
  4. Locally-Capped Contract

    A locally-capped contract is a structured investment product ...
  5. Floor Loan

    In real estate construction, the minimum loan that a lender agrees ...
  6. Reference Rate

    A reference rate uses benchmarks, like the prime rate and the ...
Related Articles
  1. Managing Wealth

    Managing interest rate risk

    Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate and directly affects the values of fixed-income securities.
  2. Investing

    Is it Time to Buy Floating Rate Bonds?

    The Fed’s awaited interest rate hike could finally be at hand. Are floating rate bonds the way to go?
  3. Trading

    Different Types of Swaps

    Identify and explore the most common types of swap contracts. Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specific ...
  4. Investing

    Float Over to Floating Rate ETFs

    Floating rate notes are another avenue for bond investors to consider when it comes to reducing interest rate risk.
  5. Insights

    The Impact of a Fed Interest Rate Hike

    When interest rates increase, there are effects on the ways that consumers and businesses can access credit and plan their finances.
  6. Financial Advisor

    Implications of the Federal Reserve's Impending Rate Hike

    The Federal Reserve begins its two-day meeting on Wednesday, September 16, and everyone is watching to see if the central bank will raise the United States target interest rate for the first ...
  7. Insights

    5 Things To Do Before Interest Rates Go Up

    It is inevitable that interest rates will go up, but what should investors do to prepare themselves?
  8. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  9. Investing

    How to Prepare for Rising Interest Rates

    Get to know the basic, time-tested strategies that any investor or trader can use to prepare and profit in a rising interest rate environment.
RELATED FAQS
  1. What is the difference between derivatives and swaps?

    Swaps comprise just one type of the broader asset class called derivatives. Read Answer >>
  2. What is the Difference Between Real and Nominal Interest Rates?

    Learn about nominal interest rates and real interest rates and the difference between the two (hint: one of them takes into ... Read Answer >>
Trading Center