A cap is an interest rate limit on a variable rate credit product. It is the highest possible rate a borrower may have to pay and also the highest rate a creditor can earn. Interest rate cap terms will be outlined in a lending contract or investment prospectus.
Breaking Down Cap
A cap is an important aspect of the terms in a variable credit product. Borrowers and investors choose variable-rate credit products to take advantage of changes in market interest rates. A cap sets a limit on how much interest a borrower has to pay and how much a creditor can earn. Common types of capped interest rate products include adjustable rate mortgages (ARMs) and floating-rate bonds.
Variable Rate Cap Products
Products with a capped interest rate have a variable rate structure which includes an indexed rate and a spread. An indexed rate is based on the lowest rate creditors are willing to offer. The spread or margin is based on a borrower’s credit profile and determined by the underwriter. If a product has a capped rate, then the interest rate will rise with increases in the indexed rate until it reaches a specified cap. The cap is advantageous for borrowers since it limits the level of interest they have to pay in a rising rate environment.
Credit products often structured with capped interest rates include adjustable-rate mortgages and floating-rate bonds. In an adjustable-rate mortgage, borrowers pay a fixed rate of interest in the first few years of the loan and then a variable rate after that. Some adjustable-rate mortgages may have rates that can change at any time while others have rates that reset at a specific time period. In the variable rate period of the ARM, a cap can be instituted at a specific level. Regardless of the time period for allowable increases, the rate can not be changed to a level that exceeds its cap if one has been instituted in the credit agreement terms.
In some cases, creditors may wish to structure a variable rate bond offering with an interest rate cap. An interest rate cap serves to benefit the bond issuer since it helps to limit their cost of capital when interest rates rise. For investors, a rate cap limits the return on a bond to a specific level. Generally, floating-rate bond products are not affected by standard market pricing mechanisms when rates rise since their interest rate levels are not fixed. However, if a bond has an interest rate cap, then the cap could adversely affect the secondary market price when the cap is reached, decreasing the trading value.
Cap versus Floor
Variable interest rate products can have both a cap and a floor. A cap limits the interest a borrower or bond issuer pays in a rising rate environment and sets a maximum level of return for the lender or investor. A floor sets a base level of interest that a borrower must pay and also sets a base level of interest that a lender or investor can expect to earn. A floor benefits the lender or credit investor in a falling rate environment. Limiting the interest base level, however, requires a borrower to pay a specified floor interest rate even when the current market rate is lower.