What Is a Cap?

A cap is an interest rate limit on a 澳洲幸运5官方开奖结果体彩网:variable rate credit product. It is the highest possible rate a borrower may pay and the highest rate a creditor can earn. Interest rate 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.

Understanding Caps

A cap is an important aspect of variable credit products. Borrowers and investors choose variable-rate credit products to take advantage of changes in market interest rates. A cap establishes a limit on how much interest a borro༺wer must pay on a loan, how much a lender or bank can charge, and a bond investor can earn.

Variable-Rate Cap Products

Products with a capped 澳洲幸运5官方开奖结果体彩网:interest rate come with a 澳洲幸运5官方开奖结果体彩网:variable rate structure that includes an indexed rate and a spread. An indexed rate is typically based on the 澳洲幸运5官方开奖结果体彩网:lowest rate creditors are willing to offer. The s🍸pread or marginꦍ is based on a borrower’s credit profile and determined by the underwriter.

With a capped rate loan, the interest rate will rise as the indexed rat🐻e increases until the loan rate reaches the specified cap. The cap helps borrowers by limiting the rate increases in a rising rate environment, saving them money.

Floating-rate bonds are credit products that may come with capped interest rates. Sometimes, creditors may include an interest rate cap when structuring a variable rate bond offering. The rate cap helps the bond issuer limit ꦚtheir 🌸cost of capital if interest rates rise.

Conversely, the rate cap limits the return on a bond to a specific level for investors. However, the cap could adversely affect the bond's secondary market price if the cap has been reached, decreasing its trading value.

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 als𓆉o sets 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. However, 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 澳洲幸运5官方开奖结果体彩网:adjustable-rate mortgage (ARM) is one of the best examples of an interest rate cap. With an ARM, borrowers pay a fixed interest rate during the initial period—usually a few years—followed by a variable rate. The mortgage lender calculates the ARM's variable rate using an underlying benchmark rate. As a result, th🌊e interest rate o🌳n the loan adjusts higher or lower as the benchmark rate increases or decreases.

The rates on some adjustable-rate mortgages can change at any time, while others reset at a specific time period. However, the terms of the loan might include a rate cap for the variable rate period, limiting the rate increase or decrease.

For example, let's say you finance the purchase of your home with a 7/1 ARM that has a 5/2/5 cap structure, whereby:

• 7: Number of years for the initial fixed rate period
• 1: Once per year rate reset following the initial period

The 5/2/5 cap structure:

• 5: Maximum rate increase of 5% for the first rate reset in the eight year
• 2: Maximum rate increase of 2% in each year following
• 5: The total rate increase or decrease cannot exceed 5% from the initial rate

In other words, your interest rate remains unchanged for the first seven years of the loan. However, 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 the total rate increase can't exceed 5% for the life of the loan.

How Is Interest Rate Cap Determined?

Multiple factors can determine rate caꦯp 🐷pricing, including:

• Interest rate expectations
• Interest rate volatility
• Loan terms
• Borrower credit rating

There are also different rate cap structures lenders can apply. With 澳洲幸运5官方开奖结果体彩网:adjustable-rate mortgages, for instance,💫 lenders use any of the following:

• Initial adjustment cap: Determines how much the interest on an ARM can increase the first time it adjusts after the fixed-rate period ends—often capped at 2% or 5%.
• Subsequent adjustment cap: Specifies how much a loan's interest rate can increase following the initial adjustment period, usually by 2%.
• Lifetime adjustment cap: How much the interest rate can increase in total over the life of the loan, which often maxes out at 5%.

Adjustable-rate mortgages can use different benchmark rates⛎ to determine rate caps. The Department of Housing and Urban Development (HUD) approves the use of these index options on FHA-insured ARM loan transactions:

• 澳洲幸运5官方开奖结果体彩网:Constant Maturity Trea꧒sury (🍸CMT) index (weekly average yield of U.S. Treasury securities, adjusted to a constant maturity of one year)
• The 澳洲幸运5官方开奖结果体彩网:Secure🌺d Overnight Financing Rate (SOFR)

Regardless of which index your lender or credit union uses, the most important thing to remembeওr is that as this rate changes, your mortgage rate can follow suit.

The Bottom Line

A cap refers to the limit on the interest rate for a variable-rate credit product. The cap prevents the rate from adjusting beyond a certain level in a rising rate environment. Adjustable-rate mortgages (ARMs) typically come with an interest rate cap limiting how much the rate can increase following the initial rate period. A cap helps protect borrowers from a significant rate increase on a variable rate loan.