THE NUMBER · THE LOAN · PRICE
A company borrows at 8% a year. Its interest is deductible, and it pays tax at 25%.
// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON
Interest Rate Floor on a Loan: a Worked Example
The loan's rate stops at zero. The swap's does not.
BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED
// THE SHORT ANSWER
A floor on a loan is the line the base rate is not allowed to cross when interest is calculated. If the market benchmark drops beneath it, the loan is priced as though the benchmark sat exactly at the floor, and the borrower keeps paying the whole margin. For the lender it guarantees that the margin, the part of the rate that pays for risk, capital and running costs, is not eaten by a falling market. For the borrower a zero floor costs nothing until rates fall very far, and then it matters most where the loan is hedged with a swap that has no floor of its own.
BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.
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// 01 — WHY A LENDER WRITES A FLOOR
A floating loan is priced as a base rate plus a margin. The base rate passes the cost of short-term money through to the borrower; the margin is the bank's price for this borrower. If the base rate goes below zero, a formula without a floor subtracts it from the margin, and the bank receives less than the price it agreed for the risk. A deeply negative base rate could take the whole rate to zero or beneath it.
That was a practical problem, not a theory. The European Central Bank's deposit rate was negative from June 2014 to July 2022, reaching −0.50%, and euro benchmarks followed it down. New Zealand, Australia and the UK cut their policy rates in 2020 to 0.25%, 0.10% and 0.10% without going negative, but many lenders in all three markets had written zero floors into their facilities by then, and many facilities still carry them. A floor can also be set above zero, in which case it bites in ordinary conditions rather than only at the extremes.
// 02 — HOW THE FLOOR IS CALCULATED
Base rate used = the higher of the benchmark and the floor
Loan rate = base rate used + margin
Benchmark 3.40%, floor 0%: 3.40 + margin
Benchmark −0.30%, floor 0%: 0.00 + margin
The drafting decides three things. The first is what is floored: the benchmark alone, which is the usual form, or the benchmark plus margin, which protects the borrower from a rate below zero rather than protecting the bank's margin. The second is the level, zero or higher. The third is when it applies. For a term rate such as BKBM or BBSY it is tested once, at the start of each interest period. For a UK loan priced on compounded SONIA, the sterling working group's guidance recommends flooring the rate each day before compounding, and says whether to floor at all, and at what level, is for the parties to decide.
// 03 — THE EXAMPLE
A hotel owner, constructed for this page like every figure in it, has a US$20m term loan at the benchmark plus a margin of 2.00%, with a zero floor on the benchmark. Its bank required the loan to be hedged, so it entered an interest rate swap on the full US$20m: it pays a fixed 1.00% and receives the floating benchmark. The intended cost is 1.00% plus 2.00%, or 3.00%. Then, in the example, the benchmark falls to −0.30%.
No floor anywhere:
Loan: −0.30 + 2.00 = 1.70%
Swap: pay 1.00, receive −0.30 = 1.30% net paid
Total: 1.70 + 1.30 = 3.00% as intended
Floor in the loan, none in the swap:
Loan: 0.00 + 2.00 = 2.00%
Swap: pay 1.00, receive −0.30 = 1.30% net paid
Total: 2.00 + 1.30 = 3.30%
Extra cost: 20,000,000 × 0.30% = US$60,000 a year
A negative floating rate under a swap means the floating receiver pays it, so the hotel pays 0.30% to the swap counterparty on top of its fixed rate. The loan does not give the matching 0.30% back, because the floor has stopped the benchmark at zero. The hedge was meant to make the cost certain; it has made it certain at a higher level. The 0.30% shortfall grows one for one as the benchmark falls further below zero.
Swaps can be written with a matching zero floor, so that the floating leg stops at zero too. That restores the 3.00%, but the swap provider charges for the embedded option, so the hedge rate is a little higher from the start. Other fixes are to floor only the unhedged part of the loan, to fix the loan's rate directly, or to hedge with a cap instead of a swap.
// 04 — HOW IT DIFFERS FROM A CAP AND A COLLAR
A floor in a loan is a term the lender writes into the facility, and the borrower is not paid for it. An interest rate cap is a product the borrower buys, which pays out when the benchmark rises above a strike. A collar combines a bought cap with a sold floor: the borrower gives up the benefit of rates falling below a level in exchange for a cheaper cap. A borrower with a collar and a floored loan is therefore floored twice: by the collar at its strike, and by the loan at zero. If the benchmark went below zero, the collar's floor would go on charging for the whole fall while the loan stopped at zero, the same mismatch as in the example.
DEFINED IN ONE PARAGRAPH → · A SWAP, FROM THE BORROWER'S SIDE → · THE HEDGING POLICY →
// 05 — WHERE IT DECIDES A FILE
The floor is set in the term sheet and often agreed without argument, because at ordinary rates it costs nothing. The time to read it is when a hedging condition is agreed. If the bank requires a share of the debt to be hedged, the borrower and its adviser should compare the floor in the facility with the floating leg of the proposed swap, and price the matching floor before signing rather than after rates fall. Where the lender and the swap provider are the same bank, the conversation is easier; where they are different, each will defend its own document.
For the credit officer the floor protects the margin modelled in the pricing, but the cost of a mismatch lands on the borrower's interest cover at exactly the time when low rates usually signal a weak economy. A file that tests cover at higher rates should also check what the hedged cost becomes if rates go the other way.
// SOURCES
The documents the statements on this page rest on. Each was opened and checked when cited.
- The Working Group on Sterling Risk-Free Reference Rates, Best Practice Guide for GBP Loans, February 2021 (updated July 2021) — appendix B, Floors — Recommends flooring the daily SONIA rate before compounding and states that whether a floor applies, and at what level, is for market participants to decide — section 02.
- European Central Bank, Key ECB interest rates — Shows the deposit facility rate below zero from 11 June 2014, at −0.50% from September 2019, and back at 0.00% on 27 July 2022 — section 01.
// QUESTIONS PEOPLE ASK
- Can a loan's interest rate go below zero?
- The benchmark can, as euro rates did for several years; the loan's rate usually does not, because many facilities floor the benchmark at zero and the margin is then added in full. Even without a floor, a loan's rate would only go below zero if the benchmark fell further below zero than the margin is above it, and most facility agreements oblige only the borrower to pay interest, not the lender.
- What is the difference between an interest rate floor and an interest rate cap?
- They protect opposite sides. A floor in a loan sets a minimum for the base rate and protects the lender's income when rates fall. A cap is a hedging product the borrower buys to limit what it pays when rates rise. A loan can have both: a zero floor written by the lender and a cap bought by the borrower from its bank or another provider.
- Why does a zero floor matter if interest rates are positive?
- While the benchmark is above zero the floor has no effect on what the borrower pays. It matters when a hedge is being agreed, because the mismatch with an unfloored swap is fixed at signing and costs the borrower only later, if rates fall below zero. A floor set above zero is different: it can bite in ordinary conditions, and its level then belongs in the price comparison.
- Does an interest rate swap have a floor?
- Not unless the parties agree one. Under the default in the ISDA definitions most swaps incorporate, a negative floating rate passes through, so the party receiving the floating rate pays it instead. A swap can be written with a zero floor on the floating leg to match a floored loan, and the swap provider will charge for that by setting a slightly higher fixed rate.
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