When considering an adjustable-rate mortgage (ARM), understanding the floor rate is crucial. This rate represents the minimum interest level your loan can reach, regardless of decreases in the benchmark rate it tracks. Essentially, the floor rate acts as a lender’s safety net, preventing your interest rate from slipping too low and potentially causing the lender a loss.
How the Floor Rate Impacts Your ARM Interest
Your ARM interest rate is calculated by adding a fixed margin to a variable index, such as the Secured Overnight Financing Rate (SOFR). The formula is:
Interest Rate = Index + Margin
For example, if your loan’s margin is 2.5% and the index is 1.5%, your interest rate would be 4.0%. However, if the index falls below a certain threshold, the floor rate limits the lowest rate you can pay. Suppose your floor rate is 3.0%. If the index drops to 0.25%, your calculated rate of 2.75% (0.25% + 2.5%) is below the floor, so your rate will stay at 3.0%.
Why Lenders Set a Floor Rate
Lenders impose floor rates to manage risk and ensure profitability. Without a floor, rapidly falling interest rates could reduce lending income below costs, exposing lenders to losses over the long term. The floor rate, therefore, guarantees a minimum return while adjustable components reflect market conditions.
Floor Rates Versus Rate Caps
An ARM typically has both a floor rate (minimum) and rate caps (maximum). While the floor protects lenders, caps protect borrowers from steep rate increases. Understanding both helps set expectations for how much your rate can fluctuate.
Where to Find Your Floor Rate
By law, lenders must disclose the floor rate to borrowers. Check your Loan Estimate and Closing Disclosure forms, specifically the Adjustable Interest Rate Table, for details. This ensures you know the limits of your loan adjustments upfront.
Key Considerations for Borrowers
A low initial ARM rate may seem attractive, but a relatively high floor can lessen the benefit if market rates drop. Always review the margin, index, caps, and floor rate with your lender before committing.
For further details on ARMs and related terms, see our glossary entries on Adjustable-Rate Mortgage (ARM) and Margin (ARM Loan).
Sources:
- Consumer Financial Protection Bureau, “Adjustable-Rate Mortgages (ARMs)” (https://www.consumerfinance.gov/ask-cfpb/what-is-an-adjustable-rate-mortgage-arm-en-122/)
- Investopedia, “Mortgage Floor: Definition, How It Works, Pros & Cons”
- NerdWallet, “What Is an ARM? How Adjustable-Rate Mortgages Work” (https://www.nerdwallet.com/article/mortgages/arm-mortgage)
