An interest rate floor is a minimum level for the base rate on a floating-rate loan. If SOFR or Prime falls below the floor, the loan is charged as if the base were at the floor, so the borrower's rate stops falling at floor plus spread. Lenders use floors to protect their return when rates drop. A floor costs nothing while the base rate sits above it and becomes real money when the base falls below. Negotiate its level, confirm it applies to the base and not the all-in rate, and match any hedge to it.
- What it limits
- How low the base rate (SOFR or Prime) can go in the interest calculation
- Who it protects
- The lender, against falling rates
- Cost to the borrower
- Zero while the base is above the floor; the difference once it falls below
- Where it is common
- Private credit and many bank loans priced off SOFR
- Main trap
- An interest rate swap that does not carry the same floor
- What to negotiate
- The level, and whether it applies to the base or the whole rate
How a floor works
A floating-rate loan is priced as a base rate plus a spread: SOFR plus a margin, or Prime plus a margin. The spread is fixed. The base moves. A floor puts a lower limit on the base: the credit agreement says that if the benchmark is below the floor on a reset date, the benchmark is deemed to equal the floor for that period.
So the floor changes nothing while rates are above it. It only acts when the base falls through it, and then it acts every period until the base climbs back. The borrower's all-in rate stops at floor plus spread, however far the market falls. That is the whole point for the lender: its own cost of funds and its return targets do not drop to zero just because short-term rates do.
| Base rate on the reset date | Floor | Base used for interest | Spread | Rate charged |
|---|---|---|---|---|
| 5.00 | 1.00 | 5.00 | 5.00 | 10.00 |
| 3.00 | 1.00 | 3.00 | 5.00 | 8.00 |
| 1.00 | 1.00 | 1.00 | 5.00 | 6.00 |
| 0.50 | 1.00 | 1.00 | 5.00 | 6.00 |
| 0.10 | 1.00 | 1.00 | 5.00 | 6.00 |
A floor is invisible until rates fall below it. Read it as insurance the borrower sells to the lender, and price it that way.
Floor on the base, or floor on the rate?
Most floors in the lower middle market are written on the base rate: SOFR is deemed to be no lower than the floor. Some agreements instead set a floor on the all-in rate: the total interest rate will be no lower than a stated level. The two read alike in a term sheet and behave differently.
A floor on the base keeps the spread intact. If the business later earns a lower spread through a pricing grid step-down, the saving passes through. A floor on the all-in rate can swallow that saving: if the floor is already binding, a lower spread changes nothing. A borrower expecting to de-lever and earn grid step-downs should push for a base-rate floor and read the definition, not the summary.
Two more details belong in the same read. Whether the floor also applies to the default rate, and whether it applies to the base rate used for letters of credit or unused fees under a revolver. Neither is usually large. Both are cheaper to settle before signing than after.
Floors and interest rate hedges
This is where floors cause real damage. Many lenders require a borrower to hedge part of a floating-rate loan, commonly with an interest rate swap: the borrower pays a fixed rate to a swap counterparty and receives floating SOFR, which it passes on to the lender. The hedge works because the SOFR received on the swap matches the SOFR paid on the loan.
If the loan has a floor and the swap does not, the match breaks when SOFR falls below the floor. The borrower pays the lender floor plus spread, but receives only the lower market SOFR on the swap, while still paying the swap's fixed rate. It pays twice for the same protection, and the fixed rate it thought it had locked in is higher than planned.
There are two clean fixes. Buy a swap that carries the same floor, so the floating leg the borrower receives never drops below what it pays on the loan; that costs a little more in the swap's fixed rate. Or hedge with an interest rate cap instead of a swap, which protects against rising rates and lets the borrower keep the benefit of falling ones down to the floor. Swap versus cap covers the trade-off, and hedging requirements covers what lenders ask for.
How floors have been negotiated as rates moved
Floors track the rate cycle. When short-term rates sat near zero, floors were binding from the first day of most loans, lenders insisted on them, and the negotiation was over the level, because every point of floor was a point of interest paid. When the Federal Reserve raised rates sharply, SOFR climbed far above most floors, and they became a secondary term that borrowers conceded to win on spread or covenants.
When rates come down from a peak, the question returns. A floor set far below the base rate at signing may still never bind; one set close to it can start to cost money within the life of the loan. In competitive processes, borrowers with strong credits can push for a lower floor, or trade a floor for a slightly higher spread, which is at least a cost they can see. Weaker credits, or deals with fewer interested lenders, tend to accept the lender's standard floor.
The useful way to decide is to ask what the floor costs in the scenarios you are planning for. If the business's plan assumes rates stay where they are, the floor costs nothing in the plan. If a refinancing or sale is likely before rates could fall below it, it may never matter. If the loan will run for years and the rate outlook is downward, a floor close to today's base rate is a real cost and should be priced against the spread.
What to ask before signing
- Where is the floor, relative to today's base rate? A floor far below it is cheap insurance for the lender; one near it is close to a fixed minimum rate.
- Does it apply to the base or the all-in rate? A base-rate floor keeps grid step-downs intact.
- Does the required hedge carry a matching floor? If not, a fall in rates leaves the borrower paying both the floor and the swap.
- Is a lower floor available for a higher spread? Compare the two on the rate scenarios in the plan, not on today's curve.
- Does the floor carry into the refinancing? If an existing loan has a high floor and rates have fallen, the floor can be a reason to refinance, once any call protection is counted.
Transparent's financing model shows debt service at the floor as well as at the current base rate and a stressed one, so the borrower sees what the floor costs before a term sheet is signed, and the lender presentation shows lenders the business carries its debt across the range. With 1,148 lenders in the book writing term and private credit, floors are one more term that can be compared across real offers rather than accepted as standard.
Common questions
- Why do lenders put floors on loans?
- To protect their return when rates fall. A lender has its own funding costs and return targets; without a floor, a drop in SOFR or Prime cuts its income on every floating-rate loan it holds. The floor keeps the base from falling below a set level in the interest calculation.
- Does a floor ever help the borrower?
- Not directly. It is a one-way protection for the lender. A borrower may accept one in exchange for something it values more, such as a lower spread, looser covenants or less amortization, which is how floors should be negotiated.
- Do SBA loans have floors?
- SBA's rules govern 7(a) pricing through a cap on the spread over the base rate, and the rate the note produces must stay within that cap at every adjustment. Read the note's rate-adjustment clause before closing for any minimum-rate language, and ask the lender to explain it against the SBA caps.
- What is the difference between a floor and a cap?
- A floor is a minimum for the base rate, protecting the lender if rates fall. A cap is a maximum, usually bought by the borrower as a hedge, protecting it if rates rise. A loan can have a floor while the borrower owns a cap, which bounds the rate on both sides.
- Can I remove a floor after closing?
- Only by amendment, which the lender will price, or by refinancing. Because floors are most valuable to the lender exactly when a borrower wants them gone, the time to negotiate the level is before signing.