What is it?

What is a cap?

An interest rate cap can be viewed as insurance for borrowers against the possibility of rising interest rates.  The borrower pays a one-off initial premium to the cap seller, normally a bank, in exchange for interest rate protection over the life of the cap.

For example, a borrower may have a 5-year, £1,000,000 loan with monthly interest payments referenced to the Bank of England Base Rate (‘Base Rate’).  If Base Rate was to rise over the duration of the loan, then the borrower’s monthly interest payments would rise accordingly.

The borrower may insure against this risk by buying a 5-year interest rate cap with a cap rate of 1%.   Then, for each monthly interest period during the next 5 years, whenever Base Rate is higher than 1%, the borrower will receive a compensating payment under the cap, which effectively caps the borrower’s Base Rate at a maximum of 1%.

If Base Rate is at or below 1% for any interest period, then the borrower will receive no income under the cap but will simply pay interest on the loan at referenced to the (low) current level of the Base Rate.

Benefits

Advantages of a cap

A cap gives the borrower the best of both worlds.  If Base Rate should fall, then the borrower benefits from lower monthly interest payments.  But if Base Rate should rise above 1%, then the borrower will receive income under the cap.  The greater the amount by which Base Rate exceeds 1%, the more income the borrower receives under the cap.

Owning a cap also improves a borrower’s creditworthiness.  This is because mortgage lenders are required to assess borrowers’ ability to pay the sums due on the assumption that interest rates will rise.   A borrower with a cap will have a higher income under that assumption than the same borrower without a cap.

Caps also provide significant advantages compared to fixed rate products.  Caps allow borrowers to benefit when interest rates fall.  Caps give optimum flexibility.  Unlike fixed rate products, which cannot be terminated early without the risk of substantial exit penalties, there are no additional costs arising from early termination of a cap.  In contrast, a borrower terminating a cap before its expiry will be entitled to receive any residual value attributable to the cap.

What is a cap?

Disadvantages of caps

The borrower incurs a premium cost to purchase a cap, usually paid up front.  If the Base Rate remains below the cap rate for the duration of the cap, the borrower may feel that they received no value.

Why Cap-It?

The hidden dangers of fixed rates

In recent years, thousands of UK borrowers have been harmed by fixed rate products.

​Fixed rate loans and interest rate swaps can be superficially attractive because they give the benefit of known, fixed, financing costs.

But they also contain hidden dangers, including contingent liabilities which may impair a borrower’s credit status, as well as the possibility of substantial break fees to escape the contracts.

​The risks of fixed rate instruments are not always understood, meaning that borrowers can find themselves caught, unwittingly, in damaging contracts, which they are unable to escape because of high exit fees.

Once trapped, borrowers may become vulnerable to predatory restructuring practices or to the transfer of their loans to vulture funds.

Small and medium-sized borrowers tend to lack the financial expertise, risk management software and trading facilities which are needed to understand, to measure and to control the risks of fixed rate instruments.

For the majority of small and medium-sized borrowers, the most appropriate interest rate hedging option is a cap. Caps protect borrowers against high interest rates without exposing them to unnecessary risks.

What is an interest rate cap?

Caps are premium products. You pay an upfront premium in exchange for the benefits a cap can give you over its lifetime. The benefits of caps include:

When interest rates rise above an agreed maximum (the ‘Cap Rate’), you will receive compensating payments under the cap.  The higher the interest rate, the greater the cap payment you will receive, ensuring that your net interest costs, after taking account of the cap reimbursements, can never be higher than the Cap Rate.

The table below shows the payments you will receive under a cap referenced to Base Rate and having a 2% Cap Rate.  The table also illustrates how the cap ensures that your net interest costs can never exceed the Cap Rate while the cap is in place.

Base Rate

Interest Payment*

Cap Receipt

Net Interest Cost*

0%

0%

0

0%

1%

1%

0

1%

2%

2%

0

2%

3%

3%

1%

2%

4%

4%

2%

2%

5%

5%

3%

2%

6%

6%

4%

2%

*Excluding lending margin.  The cap only applies to the Base Rate element of your interest payment.  The lending margin is payable on top of that.

A cap does not lock you paying into a fixed minimum rate of interest.  This is a key benefit of a cap compared to fixed rates and swaps, which leave borrowers trapped at a high rate when interest rates fall or remain low.

With a cap, when interest rates are below the Cap Rate, you are free to enjoy those low interest rates and to benefit from reduced interest costs.

With an interest rate cap you are more attractive to lenders, because there is less risk that you will be unable to meet loan payments when interest rates rise. The cap payments provide you with extra income when it is most needed.

Strict affordability guidelines require banks and building societies to reject any prospective borrower who cannot handle a jump in interest rates of three percentage points, after taking account of their incomes and outgoings. A borrower who owns an interest rate cap will earn extra income when interest rates rise above the Cap Rate, so will be more likely to satisfy the lenders’ affordability criteria.

Interest rate caps are free from the hidden risks that afflict fixed rate products, which may impair your credit status and expose you to substantial exit costs.

In recent years, thousands of UK borrowers have been harmed by fixed rate products. Fixed rate loans and interest rate swaps can be superficially attractive because they give the benefit of known, fixed, financing costs. But they also contain hidden dangers, including contingent liabilities which may impair a borrower’s credit status, as well as the possibility of substantial break fees to escape the contracts. Once trapped, fixed rate borrowers may become vulnerable to predatory restructuring practices or to the transfer of their loans to vulture funds.

Unlike fixed rate contracts, caps can be terminated at any stage without penalty. Caps provide you with full protection against high interest rates without exposing you to the hidden dangers of fixed rate products.

Interest rate caps provide flexibility because they are separate contracts from the borrowings they protect.

If you own a cap, you are free to re-organise your loans without having to adjust the cap. This means you have the flexibility to repay your loans or to switch between lenders, without touching the cap. Your cap remains in place, unaffected by any changes to your loans. For example, if you were to switch to a new lender, the cap could be used to protect the new loan.

Similarly, you can cancel or modify your cap without needing to restructure your borrowings

You pay an initial premium to buy the interest rate cap.  That is the only payment you ever have to make.  After that, all the future cap payments will be in your favour, i.e. if and when interest rates are set above the Cap Rate.

A single cap can provide flexible protection for a pool of underlying borrowings for a period of up to 10 years.

New Bridge Street House, 30-34 New Bridge Street, London EC4V 6BJ | E: caps@capit.co.uk ​| T: ​0208 004 5847 | Companies House No: 11231659

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