If you’ve read our previous article on why you should Negotiate Those Floors, then you’re already aware of what your embedded loan floor could do to your future interest expense. While many borrowers will ultimately accept a floor at some level, putting a value on this term can help when negotiating it or other points in the term sheet.
With the Fed cutting twice this year and markets expecting two additional cuts by the June 26 meeting, quantifying your loan floor is becoming increasingly important. In this resource, we’ll cover how you can negate its impact by buying out the floor.
Changes to Floor Pricing
From the peak in January 2025, front end rates declined nearly 1.00% on mixed eco data indicating stagflation (high inflation, low employment, slow growth). As a result, floor costs are currently up 50-80% since the beginning of the year across most tenors.
Below, we’ve included a graph illustrating 1-3 year historical floor pricing at a 3.00% strike.
Buying Out the Floor
An index floor is what’s in your loan, but a separate floor derivative is a contract that can be purchased similar to a cap. If your loan has a built in floor, you could enter into a floor derivative that pays you in the event your floating rate falls beneath the strike. This is commonly referred to as “buying out the floor”.
Let’s assume the following scenario:
The graph below illustrates how this would play out if SOFR reset at 2.00% in month 12.
Because SOFR is below the loan floor, you’re stuck paying 3.00%, or 1.00% more than you would if there wasn’t an imbedded floor. This is where the separate floor contract comes into play. Because the strike was set to match the loan floor, it negates its impact completely and makes it feel as if there wasn’t an embedded floor on the loan to begin with. In other words, you get the benefit of floating down to 2.00%.
To provide an order of magnitude on the cost, outlined below are some generic quotes to buy out the floor in bps of notional.
An alternative to buying a floor out completely is to buy it down by some amount. For instance, if borrower wanted to lower the index floor from 3.00% to 2.00%, a derivative could be structured with a floor bought at 3.00% and another sold back at 2.00%. The benefit of this is that borrower lowers their floor by 1.00% and reduces the upfront premium in the process.
The cost to purchase this structure for a 3 year term is 0.62%, or about 0.22% less than the vanilla 3.00% floor. To dive into how this structure works in greater detail, read about flooridors here.
Conclusion
For help determining if buying out the floor makes sense for your deal or for more specific floor pricing, reach out to the experts at PensfordTeam@Pensford.com or (704) 887-9880.