What Is an Interest Rate Ceiling?
Financial transactions often include an interest rate ceiling as part of their contractual provisions. For example, they are commonly used in adjustable-rate mortgage agreements (ARMs).
- An interest rate ceiling is a contractual provision outlining the maximum interest rate permitted for that transaction.
- They are commonly used in variable-rate loans, such as ARMs.
- Together with similar measures such as capped increase provisions, interest rate ceilings are designed to protect borrowers against interest risk. However, they can also benefit lenders by reducing the risk that borrowers will default on their loans.
How Interest Rate Ceilings Work
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 been a part of commerce for thousands of years, where they have traditionally served to protect borrowers against predatory lending practices.
In recent times, however, interest rate ceilings are often used to protect against interest rate risk. That is, to protect borrowers against the risk that interest rates might rise significantly during the life of a particular contract.
Usury laws have ancient origins and have existed in every major religious tradition; U.S. usury statutes were based on the English model and are designed to curtail abusive lending practices.
In addition to specifying a maximum interest rate level, variable rate loans can also include conditions for how quickly interest rates can rise up to that maximum level. Often, these so-called “capped increase” provisions will be set at roughly the rate of inflation, which hovers around 2% today.
Generally speaking, interest rate ceilings and capped increase provisions are particularly beneficial to borrowers when interest rates are rising overall. After all, if a max interest rate is reached before a loan reaches its maturity, it is possible that the borrower will be able to pay below-market rates of interest for a long period of time. This creates an opportunity cost for the bank because, if not for the interest rate ceiling, they could lend their money to a new borrower at the newer and higher rate of interest.
In the United States, as well as in several other countries throughout the world, various laws and regulations exist relating to interest rate ceilings. One common example is usury laws, which outline the maximum interest rates that are permissible under law. Typically, these rates hover around 35%, although exceptions do exist for some lenders, such as those specializing in payday loans.
Real-World Example of an Interest Rate Ceiling
To illustrate, consider the case of an ARM. A borrower may be quite capable of servicing an ARM at the interest rates prevalent at the time that mortgage was negotiated. However, if interest rates continue to rise indefinitely throughout the duration of the mortgage, most borrowers will eventually become unable to service the loan. To protect against this, ARM contracts often include interest rate ceilings which ensure that the interest rate used in the loan cannot rise beyond a certain level during the mortgage term.
In many ways, this provision is a benefit to both parties: in addition to reducing the borrower’s interest rate risk, it also reduces the risk that the borrower will default on their loan, thereby reducing the lender’s risk.