An interest rate floor is the minimum interest rate possible for anadjustable rate mortgage.
The lowest rate an ARM get have over its term. This is to keep mortgage lenders from losing money if ARM interest rates drop below the cost of lending the money and servicing the mortgage. It is similar to the interest rate ceiling that protects borrowers from ARM rates becoming too high to be affordable.
The economy is constantly changing and one of the ways that these changes are reflected is in interest rates on mortgages. Adjustable-rate mortgages have rates that move up and down according to a standard rate index. Some mortgages, known as hybrids offer fixed rates for an initial time period and then switch to adjustable rates. For instance, the 5/1 ARM has a fixed rate for five years and afterward adjusts your rate once a year.
Lending is a huge industry and one of the ways that lenders are able to offer the services they do is through interest rates. The profits made through interest paid on loans keep a company and its employees in good financial standing. Interest rates also help generate enough profit to replenish funds available for lending to other borrowers.
Since interest rates fluctuate on ARMs, lenders have to protect themselves from a dramatic change in the market. That is why they establish interest rate floors. If a borrower with an ARM had a very competitive interest rate at a certain time period and then the market changed drastically enough to make that person’s interest rate out of line with current rates, then the lender would not be able to make any profit at that interest rate. In other words, an interest rate floor ensures that a borrower’s interest rate stays at least at a certain percentage so that the borrower is not borrowing money for free.
There is a flip-side to interest rate floors, called interest rate ceilings. The interest rate ceiling is the highest interest rate possible on an ARM. You may hear this called the lifetime cap, and it based on the number of percentage points your rate can increase from your initial rate. Just like the interest rate floor can help protect lenders from a significant decrease in profits, interest rate ceilings can help protect borrowers from changes in the economy that could result in soaring interest rates.