DEFINITION of Capped Rate
A capped rate is an interest rate that is allowed to fluctuate, but which cannot surpass a stated interest cap. A capped rate loan issues a starting interest rate that is usually a specified spread above a benchmark rate, such as LIBOR. For example, the loan's rate might be LIBOR +2%. Then, the loan rate fluctuates based upon the bench rate's movement.
BREAKING DOWN Capped Rate
Capped rates are supposed to provide the borrower with a hybrid of a fixed and variable rate loan. The fixed part happens when the rate of the loan starts to go above the capped rate but the cap acts as a ceiling and keeps the loan rate from rising. The variable part comes from the loan's ability to move up (until it hits the cap) or down with market fluctuations. The capped rate structure also allows some protection to the lender in that they are able to participate in market upside and receive higher interest rate payments up to the cap as rates increase.
If the variable rate on a similar loan goes above the capped rate, the capped rate loan holder gets the benefit of not having to pay the extra portion. While this is a benefit, capped rate loans can have higher interest rates than a traditional fixed rate loan. This is because the lender misses out on increasing interest payments if interest rates above the cap, and also gets the short end of the stick if rates fall below the starting interest rate.
For example, a 10-year capped rate loan may be issued to a borrower at 6%, but with a capped rate of 9%. The interest rate can fluctuate up and down depending on the activity of the underlying rate benchmark, but can never go higher than the 9% capped rate.