Interest Rate Caps

Interest rate cap definition

An interest rate cap is a defined limit on how far upward the interest rate can move on an adjustable rate mortgage or loan. Most commonly used in mortgage contracts, interest rate caps are intended to serve as a shield against inflation and consequent rising interest rates. Interest rate caps are most commonly seen in adjustable rate mortgages, where they limit the amount of increase on regularly scheduled interest rate adjustments.

Types of interest rate caps

There are three basic varieties of interest rate caps. An initial interest rate cap applies only to the first adjustment on a loan and serves as a short-term guarantee for borrowers against sizable fluctuations in the interest rate. Periodic interest rate caps limit the amount by which interest rates can increase at each adjustment date after the initial period, but put no limits on the overall rate to which interest may be raised on the loan. Lifetime caps offer overall protection against major shifts in the interest rate by limiting the rate charged to a specific predetermined amount. Some loan agreements incorporate all three interest rate caps into their terms; others may include only one or two of these interest rate cap provisions.

How do interest rate caps work?

In practice, interest rate caps shield borrowers from major shifts in prevailing interest rates by setting a fixed maximum percentage above which interest rates cannot rise at a single time. For instance, a typical 2-2-6 interest rate cap structure for a standard adjustable-rate mortgage would limit the potential initial adjustment to two percent, the periodic interest rate increase to two percent each time, and the overall interest rate cap for the life of the loan would be set to six percent over the starting interest rate. Essentially, this means that the interest rate for the entire loan could not increase more than six percent and both the initial and all subsequent adjustments could not exceed two percent at any given adjustment date, regardless of the increase in the prevailing interest rates. Interest rate caps on mortgage loans tend to be relatively small, with 5-2-5 and 2-2-6 interest rate cap structures being the most common types of adjustable-rate mortgage interest rate caps.

How do interest rate caps work for options?

Mortgages are not the only type of financial transactions that utilize interest rate cap structures. Options contracts including FOREX transactions often incorporate interest rate caps, also known as interest rate ceilings, in order to limit the issuer’s financial liability if interest rates increase significantly during the term of the contract. The types of interest rate caps available for options and other financial contracts are materially the same as those available for mortgages and serve the same basic purposes.
Tim Ord
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