In order to understand the concept of interest rate floor, it is vital to first take up the topic of loan products having variable interest rates. Now, a loan product having a variable interest rate essentially indicates a loan arrangement under the provisions of which, the interest rates that are chargeable on a total loan amount are subject to variation with respect to market changes. Under such loan arrangements, the interest rates levied by loan lenders or financial institutions are not definite or inflexible. Rather, they are adjusted on a periodic basis.
Now, let us come to the concept of the interest rate floor. An interest rate floor virtually indicates the lowest possible interest rate that such variable interest rates can scale down to. It is referred to as a mutually established rate in association with floating rate loan products.
An interest rate floor is affiliated with variable rate loan products and effectively denotes the lowest possible interest rates that be reached under the provisions of such loan products. It should be noted that interest rate floors are adopted in loan agreements and derivative contracts. It offers considerable protection to the lenders or lending institutions under such loan contracts.
Additionally, it should be noted that interest rate floors are applied in contrast to interest rate ceilings whereas interest rate ceilings denote the maximum interest rate that a lender is permitted to levy on a particular loan.
In the real estate industry, interest rate floors are most commonly prevalent in adjustable-rate mortgage loans. Now, an adjustable-rate mortgage is a type of home loan where the rate of interest chargeable by the lender is not a fixed one. Under the provisions of such loans, the interest rates are subject to quarterly evaluation and revision.
It has been recognized that adjustable-rate mortgage loans, owing to their adjustable nature, may even offer interest at unreasonably lower rates which in turn would cause a loss on part of the lender. This is where the concept of the interest rate floor comes into the picture. It effectively protects the lenders of adjustable-rate mortgage loans from interest rates descending beyond levels set in advance.
Interest rate floors are previously established rates of interest that are conveniently employed by loan lenders to circumvent the risks associated with floating rate loan products such as adjustable-rate mortgages. Here, the primary objective is to ensure that a minimum interest estimate can be levied on floating rate loans even if the adjustable rates fall to 0%.
