Definition:
An interest rate floor is the lowest possible interest rate that can be charged on an adjustable-rate mortgage (ARM), regardless of how low market rates may drop. It sets a minimum limit on how low your interest rate can go.
Example:
Rachel takes out a 5/1 ARM with a starting interest rate of 4% and an interest rate floor of 3%. Even if market rates fall significantly, her mortgage rate will never go below 3%, because of the floor set in her loan terms.
Explanation:
Adjustable-rate mortgages (ARMs) have interest rates that can go up or down based on market trends after the initial fixed-rate period. While borrowers benefit when rates go down, lenders protect themselves by setting an interest rate floor. This floor guarantees the lender will always receive a minimum amount of interest, even if general market rates drop below that level.
For example, if a borrower’s loan is tied to an index (like SOFR or the U.S. Treasury rate) and the index drops, their interest rate might decrease too—but only to the floor, not below. If the floor is set at 3% and the rate calculation falls to 2.5%, the borrower will still pay 3%.
Interest rate floors are written into the loan agreement and are part of the overall interest rate cap/floor structure that defines how much a borrower’s rate can adjust over time.
Why is Interest Rate Floor Important in Real Estate Transactions?
Interest rate floors are important because they affect how much a borrower might save when rates decline. For buyers, understanding the floor helps set realistic expectations about how low their monthly payments can go. For sellers and lenders, disclosing this information up front builds trust and ensures borrowers make fully informed decisions about financing options.