What Is an Interest Rate Ceiling?
An interest rate ceiling is the maximum interest rate permitted in a particular transaction. It is the opposite of an interest rate floor.
Financial lending instruments may include an interest rate ceiling as part of their contract provisions. They are commonly used in adjustable-rate mortgage agreements (ARMs).
- An interest rate ceiling is a contract provision that sets the maximum interest rate permitted in financing a loan.
- They are commonly used in variable-rate loans, such as ARMs.
- Interest rate ceilings protect borrowers against interest rate risk and reduce the risk of default.
Understanding Interest Rate Ceilings
An interest rate ceiling, also known as an interest rate "cap," is the maximum interest rate that a lender can charge a borrower when negotiating a loan. Interest rate ceilings have played a role in commerce throughout history, protecting borrowers from predatory lending practices. Usury laws were established to prohibit lenders from charging an illegal rate of interest for a loan.
Interest rate ceilings also protect borrowers against interest rate risk, when market interest rates may rise significantly during the life of a loan.
Usury laws prohibit lenders from charging borrowers excessively high rates of interest on loans. In the establishment of the United States, colonies adopted usury statutes based on the English model.
Interest rate ceilings are found in variable-rate loans, where the rate is allowed to fluctuate during the life of the loan. Variable-rate loans may also include conditions for how quickly interest rates can rise to that maximum level. These "capped increase" provisions will be set at roughly the rate of inflation.
Interest rate ceilings and capped increase provisions are particularly beneficial to borrowers when interest rates are rising overall. If a maximum interest rate is reached before a loan reaches its maturity, the borrower may be able to pay below-market rates of interest for an extended period.
Variable interest rates create an opportunity cost for the bank because, without the interest rate ceiling, they could lend their money to a new borrower at a higher rate of interest.
When considering an Adjustable Rate Mortgage (ARM), a borrower may be capable of paying the loan with the prevailing interest rates at the time that the mortgage is negotiated. However, If interest rates were to rise uncapped throughout the life of the mortgage, commonly a period of 15 or 30 years, a borrower may be unable to service the loan.
The interest rate ceiling included in the ARM loan ensures that the interest rate cannot rise beyond a certain level during the mortgage term. In addition to reducing the borrower's interest rate risk, it also protects the lender from the possibility of a borrower's default on their loan.
How Do Banks Set Interest Rates for Loans?
The prime rate is an interest rate determined by individual banks and used as a reference rate, or base rate, for many types of loans. Banks set their prime rates based partly on the target level of the federal funds rate, established by the Federal Open Market Committee, and it is the rate that banks charge each other for short-term loans.
What Is an Interest Rate Floor?
An interest rate floor is the minimum interest rate that may be charged on a contract or loan agreement. It reduces the risk to the lender by capturing a minimum cost of the loan from the borrower.
Is There a Limit to Interest Rates?
The United States does not set a single maximum interest rate. Usury laws vary by state so the interest rate you may get for an approved loan depends on the loan product you’re qualified for and where the lender is headquartered.