What Is Interest Rate Ceiling
An interest rate ceiling (or cap) is the maximum interest rate that a lending institution can charge a borrower on a loan. If a loan has an interest rate ceiling, it will be detailed in the contractual terms of the loan.
Ceilings are often used in the adjustable rate mortgage (ARM) market. Often, this maximum is designed to limit the amount a borrower can expect to pay if rates rise in the future in order that the bank can still expect them to service their loans without defaulting. An interest rate ceiling is often present through the issuing of an ARM, as it prevents interest rates from adjusting above a preset level.
It can be contrasted with an interest rate floor, which is a lower limit a bank will charge.
Interest Rate Ceilings Explained
Interest rate ceilings can be integrated into a borrower’s loan terms for a few different reasons. Some lenders may use an interest rate ceiling to increase the marketability of a variable rate product. In many cases, interest rate ceilings may also be instituted due to government regulations known as usury laws.
Interest rate ceilings are used in variable rate products. If a product has an interest rate ceiling, the borrower will specify a maximum rate, which will serve as the highest rate that a lender will charge on a loan.
Adjustable rate mortgages commonly include provisions for interest rate ceilings and incremental interest rate increases during the variable rate portion of the loan. The ceiling may also be known as the lifetime maximum rate. With this product, the variable rate can only be increased up to the specified ceiling rate. If an adjustable rate mortgage loan also has a capped increase then the borrower’s rate can only be increased by a specific percentage when rates are rising. Often a capped increase will be approximately 2%.
Overall interest rate ceilings and capped interest rate increases are a benefit for borrowers in variable rate products when rates are rising. If a product has reached its interest rate ceiling, it will remain at that level until rates begin to decrease at which time the rate could be lowered.
Interest Rate Regulations
Across the U.S. and around the world, governments have various regulations for legal interest rate ceilings. In the U.S., individual states regulate interest rate levels through usury laws. Usury laws apply a maximum rate of interest that can be charged for borrowers in lending products. Certain exceptions may apply to individual usury laws, specifically for payday lenders.
However, most traditional banks are subject to state usury limits. Usury caps are a regulated ceiling that lenders must adhere to in all types of loans and credit card offerings. They apply to both fixed interest rate products and variable rate interest products. Usury rates can range up to approximately 35%. Thus, in some cases, variable rate interest products may have an interest rate ceiling that is dictated by a state’s usury cap rather than the lender of the product itself.