What Is a 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 the London InterBank Offered Rate (LIBOR).
- A capped rate is an interest rate on a loan that has a maximum limit on the rate built into the loan.
- A capped rate adjusts based on a benchmark interest rate below the limits of the cap.
- Capped rates limit the borrower’s risk of rising interest rates and allow the lender to earn a higher return when rates are low.
- Capped rate loans can be structured in many different ways, with various fixed and capped components and limits on adjustments over time.
Understanding a 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 the 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.
Oftentimes, the capped rate on such loans may be limited to a certain period. For example, the interest rate on adjustable-rate mortgages may be capped for the first 2 to 5 years of the loan. Then at that time the rate of the loan can be changed to a pure floating rate or reset to a capped rate with a new cap based on market rates at that time. This new capped rate can also then be reset periodically, usually every 12 months.
The amount that the rate is adjusted by each year can also be capped so that the rate can only increase by a certain amount. Finally, the adjustable-rate can still have an overarching cap that represents an absolute maximum interest rate after any other adjustments, caps on rate resets, or expiration of an initial fixed-rate are taken into account.
Example of a Capped Rate
For example, the loan's rate might be the London InterBank Offered Rate (LIBOR) plus 2%. Then, the loan rate fluctuates based upon the benchmark rate's movement. A capped rate limits the borrower's risk that market interest rates might rise while allowing them to benefit from falling rates.
Because the borrower pays for this by paying a higher adjustable rate than they would on a pure floating rate, the lender benefits by being able to earn a higher rate on the loan during periods when market rates are low.