What Is a Cap Definition on Credit Products and How It Works
What Is a Cap? Definition on Credit Products and How It Works
What Is a Cap?
A cap is an interest rate limit on a variable rate credit product. It is the highest rate a borrower may have to pay and the highest rate a creditor can earn. Cap terms will be outlined in a lending contract or investment prospectus. Common types of capped interest rate products include adjustable-rate mortgages (ARMs) and floating-rate bonds.
Key Takeaways:
– A cap is a limit on the interest rates a variable-rate credit product can charge.
– The cap limits the interest levels that borrowers have to pay in rising rate environments.
– Variable interest rate products can have both a cap and a floor, which sets a base level of interest that a lender or investor can expect to earn.
– Adjustable-rate mortgages typically have a rate cap to limit how much interest homebuyers pay for a home loan.
Understanding Caps:
A cap is an important aspect of the terms of a variable credit product. Borrowers and investors choose variable-rate credit products to take advantage of changes in market interest rates. A cap sets a limit on how much interest a borrower has to pay and how much a creditor can earn.
Variable-Rate Cap Products:
Products with a capped interest rate have a variable rate structure that includes an indexed rate and a spread. An indexed rate is based on the lowest rate creditors offer. The spread or margin is determined by the borrower’s credit profile and the underwriter.
If a product has a capped rate, the interest rate will rise with increases in the indexed rate until it reaches a specified cap. The cap is advantageous for borrowers because it limits the interest they have to pay in a rising rate environment.
Credit products often structured with capped interest rates include floating-rate bonds. In some cases, creditors may structure a variable rate bond offering with an interest rate cap. An interest rate cap benefits the bond issuer by limiting their cost of capital when interest rates rise. For investors, a rate cap limits the return on a bond to a specific level.
Generally, floating-rate bond products are not affected by standard market pricing mechanisms when rates rise because their interest rate levels are not fixed. However, if a bond has an interest rate cap, the cap could adversely affect the secondary market price when reached, decreasing the trading value.
Tip:
You can purchase floating-rate bonds through the U.S. Treasury at TreasuryDirect.
Cap vs. Floor:
Variable interest rate products can have both a cap and a floor. A cap limits the interest a borrower or bond issuer pays in a rising rate environment and sets a maximum level of return for the lender or investor. A floor sets a base level of interest that a borrower must pay and a base level of interest that a lender or investor can expect to earn.
A floor benefits the lender or credit investor in a falling rate environment. Limiting the interest base level requires a borrower to pay a specified floor interest rate even when the current market rate is lower.
Example of Interest Rate Cap:
An adjustable-rate mortgage (or ARM) is one of the best examples of an interest rate cap in a lending setting. In an adjustable-rate mortgage, borrowers pay a fixed rate of interest in the first few years of the loan and then a variable rate after that. This variable rate is determined by an underlying benchmark rate; when the benchmark rate increases or decreases, the interest rate on the loan can adjust accordingly.
Some adjustable-rate mortgages may have rates that can change at any time, while others have rates that reset at a specific time period. In the variable rate period of the ARM, a cap can be instituted at a specific level.
For example, say you buy a home with a 7/1 ARM that has a 5/2/5 cap structure. For the first seven years of the loan, your interest rate will remain unchanged. But in the eighth year, your mortgage rate can increase by up to five percentage points. In each subsequent year, your rate can increase by two percentage points, but your total rate increase can’t exceed 5% for the life of the loan.
Note:
Regardless of the time period for allowable increases, the rate cannot be changed to a level that exceeds its cap if one has been instituted in the credit agreement terms.
How Is Interest Rate Cap Determined?
Rate cap pricing can be determined by factors such as interest rate expectations, interest rate volatility, loan terms, and borrower credit rating.
There are also different rate cap structures lenders can apply. With adjustable-rate mortgages, for instance, lenders use initial adjustment caps, subsequent adjustment caps, and lifetime adjustment caps.
Tip:
If you’re buying a home using an adjustable-rate mortgage, be sure to read over your loan estimate and closing disclosure carefully to understand your loan costs and how your rate cap works.
Adjustable-rate mortgages can use different benchmark rates to determine rate cap. The Department of Housing and Urban Development (HUD) approves the use of index options on FHA-insured ARM loan transactions, such as the Constant Maturity Treasury (CMT) index and the 1-year London Interbank Offered Rate (LIBOR).
Regardless of which index your lender uses, the most important thing to remember is that as this rate changes, your mortgage rate can follow suit.
