Definition
Floor Rate
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A floor rate in a figure expressed in percentage that indicates the minimum interest that is to be charged on a home loan.
It can also be referred to as the minimum rate.
Floor rate typically protect lenders from being exploited during times of market volatility.
For example, SIBOR packaged housing loans consist of SIBOR and a spread. Because the SIBOR index fluctuates according to market conditions, it can sometimes fall way below banks’ expectations.
If the floor rate for SIBOR is set at 0.10% stipulated in the offer letter, then even if SIBOR drops below 0.10%, the interest charged on the borrower would be 0.10% plus the spread. When the loan package consist of the index SIBOR plus a spread of 0.75%, the the interest rate would become 0.10% + 0.75% = 0.85%.
Since the total interest rate such mortgages charge on borrowers, a sudden collapse in SIBOR can create a situation where the interest income collected from borrower is simply unable to sustain their operations.
Thus, the introduction of a floor rate inserted as a clause in the loan contract protects the bank from losses.
An example of the floor rate coming into play was in the early 2010s when SOR turned negative. Yet borrowers were unable to benefit from the negative value but were charged the floor rate indicated in their loan packages accordingly.
Floor rates can be enforced either on the fully index rate or only on the index rate portion of the credit facility.
In light of the unpredictability of SIBOR and SOR during that period, banks slowly moved to fixed deposit rate loans to bring more stability to consumers.
On the other end of the spectrum some housing loans provide a rate ceiling to protect borrowers from payment shock. These terms state a maximum rate that borrowers would have to pay even if the market determines a rate higher than the max rate stated.
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