1. What is an interest rate cap?
An interest rate cap acts like insurance against high interest rates.
Caps are typically purchased by borrowers with variable rate loans, as a separate contract to the loan. The cap protects the borrower against the possibility of interest rates rising above a chosen maximum, the cap rate.
The cap buyer pays a premium for the cap in exchange for extra income when a specified benchmark interest rate exceeds an agreed cap rate. The further the benchmark rate exceeds the cap rate, the greater the extra income from the cap. The cap income offsets the higher interest cost of the variable loan.
When rates are below the cap rate, the borrower receives no income from the cap but simply pays the lower variable rate.
The effect of the cap is that the borrower’s net interest cost (not including the lender’s margin) can never be higher than the agreed cap rate.
Borrowers owning interest rate caps have less risk of being unable to meet loan payments when interest rates rise and are correspondingly better placed to pass lenders’ affordability assessments.
The risk of a cap is that the buyer pays a premium for the cap but receives nothing in return, for example if interest rates remain below the cap rate for the duration of the instrument.