Interest Rate Floor Example
Now you know what a floor rate means. But the concept can be a little hazy 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 that 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 a 5% interest rate floor. As you come up on the 5-year mark, you discover that interest rates are sitting around 4%. But since you’ve agreed to the 5% floor, you’ll never see your rate drop below5%.
Ultimately, the interest rate floor means that you won’t save as much as you could when interest rates fall. But when accompanied by an interest rate cap, these safeguards can help prevent your mortgage payment from outgrowing your budget.
Lending Interest Rate Floor
Now, let’s look at this from the lender’s point of view. As a lender, you are structuring an ARM with a mortgage client. The home buyer wants a 5/1 ARM.
Based on the economic conditions of the day, you might decide that falling rates are a possibility. Since you don’t want to lose money on the loan, you stipulate a 5% floor rate in the contract. If the benchmark interest rate falls below 5%, you can still charge the client a 5% interest rate on their loan.
Typically, lenders are very interested in including an interest rate floor. The goal is to protect their investment from losing money if market interest rates fall too far.