Written byA floor rate is the minimum interest rate a variable loan contract allows; lenders also use the phrase for the minimum rate they test serviceability against.
Also known as: interest rate floor, rate floor, assessment floor rate
Key points
- A floor stops your rate falling past a set level, so cuts in the market may not reach a variable rate loan.
- Floors are common in commercial, property and asset finance, where lenders protect a minimum return on the money they have lent.
- Lenders also use an assessment floor rate: a minimum rate they test your repayments against, whatever rate you are actually offered.
- Check the rate clause before you assume a cut will reach you, and compare the total cost over the full term.
How a floor rate works
A floor rate is written into the loan contract as a minimum. The rate is still variable, so it can rise, and it can fall while it sits above the floor. Once it reaches the floor it stops there, even if the benchmark it is priced from keeps dropping. The effect is that the lender keeps a minimum return on the money it has lent out.
Assessment floor rates
The same phrase is used a second way, in credit assessment. When a lender works out whether you can afford a loan, it does not test you at the rate on offer. It adds a buffer, and many lenders also apply a floor: a minimum assessment rate that is used even when the actual rate is lower than it.
That is a prudential and responsible lending practice rather than a term of your contract. It exists because rates move over the life of a loan. APRA sets expectations for how regulated lenders do this, which is why a lender's view of affordability can look conservative next to the advertised rate.
What to check before you sign
Read the rate clause, not just the headline number. Ask whether there is a floor, where it sits compared with the rate today, and whether it applies for the whole term or only part of it. On a long asset finance contract a floor can outlast several rate cycles. A comparison rate is only published for regulated consumer credit, so on a commercial or asset facility the figure to hold beside a rival quote is the total cost over the term.
If a floor is a deal breaker, other lenders may not use one, or may set theirs lower. A broker can compare the clauses as well as the rates. If what you really want is certainty about repayments, a fixed rate does that job more directly.
Example
A transport operator finances a $300,000 prime mover on a variable commercial facility with a floor written into the contract. Over the next two years the benchmark falls several times. The rate on the facility drops with the first few moves, then stops at the floor and stays there while the market keeps easing. The repayments are still lower than they were, but not as low as the benchmark alone would suggest. A competing lender without a floor would have kept passing the falls through.
Not to be confused with
- Variable rate
- a floor rate is a limit written into a variable loan, not a rate type of its own
- Fixed rate
- a fixed rate locks movement in both directions, while a floor only stops the rate going down
Frequently asked questions
What does floor rate mean on a loan?
It means the lowest rate the contract allows. Your loan is still variable and can rise, but it cannot drop below the floor no matter what happens to the benchmark. The clause is usually in the rate section of the contract rather than the marketing material.
What is the difference between a floor rate and a cap rate?
They are opposite limits on the same variable loan. A floor sets the minimum rate you can pay, protecting the lender when rates fall. A cap sets the maximum, protecting you when rates rise. A contract can contain one, both or neither.
Why do lenders use a floor rate?
To protect their margin. A lender's own costs do not fall all the way as benchmarks drop, so a floor keeps a minimum return on the loan. It is most common in commercial and asset finance, where facilities can run for many years.
What is an assessment floor rate?
It is the minimum rate a lender uses when testing whether you can afford repayments, applied on top of or instead of a buffer. It has nothing to do with the rate you are charged. It exists so that a loan approved today still works if rates rise later.
Do all variable loans have a floor rate?
No. Many consumer loans have no floor at all, and lenders that use one set it at different levels. Because it is a contract term rather than a market rule, the only reliable way to know is to read the credit contract or ask the lender directly.
Related terms
Variable rate
A variable rate is an interest rate that can move up or down over the life of a loan, following the lender's benchmark and its margin.
Read definitionFixed rate
A fixed rate is an interest rate locked in for a set term, so the rate and usually the repayments do not change until that term ends.
Read definitionInterest rate risk
Interest rate risk is the exposure a financial asset, liability or portfolio has to changes in market interest rates, which alter the present value of its future cash flows.
Read definitionRate
A rate is a ratio or charge expressed against a unit, commonly per year, that measures cost, return or proportion; in finance it usually means an interest rate.
Read definitionSpread (finance)
A spread is the difference between two related rates or prices, such as a lender's rate and its benchmark, or an asset's buy and sell price.
Read definitionComparison rate
A comparison rate is a single annual percentage that combines a loan's interest rate with most upfront and ongoing fees to show its ongoing cost more clearly.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.