Ah, the ever-changing economy. One day interest rates are up, the next day they’re down. Not exactly a roller coaster, but it’s at least a merry-go-round. Those rates impact the mortgages banks offer to their customers, adjustable rate mortgages most of all. Customers choose ARMs because they’re betting the rates aren’t going to go up too much over the course of the life of the loan. Sometimes they win on that proposition, sometimes they don’t. We get word of the changes on the wind, but we’re never really certain what’s going to happen with rates until it comes. The fact that rates fluctuate is the reason we have rate caps and floors, especially for loans with ARMs.
Rate caps and floors mean protection for the bank and the borrower
Currently, the Fed has been inching rates upward from historic lows. But what if they come down again? It’s a delicate dance, the rate floor shuffle, but now’s the time to get out there and boogie. As the rates are rising, it’s time to put in a rate floor.
Rate caps protect the consumer from loan Armageddon and protect the banks from possible default if rates spike into the stratosphere. And in this economy, who knows? If a borrower gets an ARM at the going rate of 3.5 percent, and the interest rate spikes to, say, 7 percent when it comes time to adjust the loan, that means a big spike in the borrower’s monthly mortgage payment. If they can afford to pay it, great. If not, it means trouble for both the borrower and the bank. It’s why ARMs fell out of favor after the big crash in 2009. Hence the need for rate caps.
Similarly, rate floors protect the banks’ profit margins if rates go into the tank. Investopedia delivers a succinct explanation: “An interest rate floor is an agreed upon rate in the lower range of rates associated with a floating rate loan product. Interest rate floors are often used in the adjustable rate mortgage (ARM) market. Often, this minimum is designed to cover any costs associated with processing and servicing the loan.”
Here’s one example: Take that same ARM for 3.5 percent, with a 3 percent floor. If the interest rate falls below 3 percent, that’s all well and good for borrowers initiating new loans, but for that particular ARM, the rate will not go below 3 percent. In this way, it reduces the risk to the bank receiving the interest from this loan.
More than one reason to think about rate floors
Thinking about rate floors and caps isn’t just a matter of the fluctuating interest rate. It’s also a matter of the fluctuating population rate.
Sure, millennials and Gen Z are getting all of the marketing hype right now, and it’s true that they are the future for growth in financial institutions as they get married, take out loans for mortgages, start businesses, demand digital everything, choose FI services with a cherry picker, and change banking as we know it. But boomers? Don’t count them out just yet.
According to the U.S. Census Bureau, within the next decade, seniors will outnumber children in the U.S. for the first time in history. Boomers right now are between the ages of 55 and 73. Does that seem old to anyone? Today, more than ever before, people in that age group are still active, living longer and working well beyond traditional retirement age. But, they don’t have the same sorts of lending and financial needs as their younger counterparts. The IMF recently did a study about how that shift in population affects financial institutions and found that, as older consumers’ needs for lending decline, banks will see a decline in their loan-to-deposit ratios, to the tune of 40 percentage points within 20 years. Ouch.
With more of the population needing less in the lending space, it means banks need to be rock solid in terms of protecting their bottom lines. Changing the entire business model isn’t out of the question, but until that time comes, banks need to make sure nothing eats into profits on any single loan. Rate floors are one way to do that.