Interest Rate Cap Structure

What is 'Interest Rate Cap Structure'

Interest rate cap structure refers to the provisions governing interest rate increases and limits on a variable rate credit product. Interest rate caps can be instituted across all types of variable rate products. They are commonly used in variable rate mortgages and specifically adjustable rate mortgage (ARM) loans.

BREAKING DOWN 'Interest Rate Cap Structure'

Interest rate cap structures serve to benefit the borrower in a rising interest rate environment. They can also increase the marketability of a variable rate interest product for customers.

Variable Rate Interest

Lenders can offer a wide range of variable rate interest products. These products are most profitable for lenders when rates are rising and most attractive for borrowers when rates are falling.

Variable rate interest products are designed to fluctuate with the changing market environment. Investors in a variable rate interest product will pay an interest rate that is based on an underlying indexed rate and a margin. The combination of these two components results in the borrower’s fully indexed rate. Lenders can index the underlying indexed rate to various benchmarks with the most common being their prime rate, LIBOR or a U.S. Treasury rate. Lenders also set a margin in the underwriting process based on the borrower’s credit profile.

A borrower’s fully indexed interest rate will change with changes in the underlying indexed rate. Interest rate caps can limit the incremental increase in a borrower’s fully indexed rate and also set a maximum rate. Thus, interest rate caps can give borrowers protection against dramatic rate increases and also provide a ceiling for maximum interest rate costs.

Interest Rate Limits

Interest rate cap structuring can take various forms. Lenders have the flexibility to customize interest rate limits and may choose to do so in various ways. Generally, they may institute a limit on incremental increases and will also set a flat rate limit that the interest rate cannot exceed over the life of the loan.

Adjustable rate mortgages provide many examples of interest rate cap structure variations. For example, a 5-1 ARM requires fixed rate interest for five years followed by variable rate interest after that which resets every 12 months. In this mortgage product borrowers can often choose between a 2-2-6 or a 5-2-5 interest rate cap structure. In these quotes the first number refers to an initial incremental increase cap, the second number is a periodic 12-month incremental increase cap and the third number is a lifetime cap setting the maximum interest rate ceiling.