Interest Rate Cap Structure – How Interest Rate Caps Work

What is the Interest Rate Cap Structure?

An interest rate cap is an insurance policy on a floating rate, most frequently 1-month LIBOR. The interest rate cap has three primary economic terms,  they are: notional, term, and strike rate.

Caps are typically bought upfront with a single premium payment. And can also be terminated at no cost by the purchaser of the cap. With a determined upfront payment and no prepayment penalty. Caps are a commonly used interest rate hedge utilized by borrowers. This is mostly for shorter-term debt on transitional assets that need flexibility for a refinance or sale. As caps permit an investment to be underwritten to a worst-case interest expense. Floating-rate lenders will commonly require their purchase as a condition to closing a loan.

Interest Rate Cap

How Interest Rate Caps Work

Interest rate cap structures are geared at benefiting the borrower in a rising interest rate environment. The caps can also make variable rate interest products more attractive as well as financially feasible for customers.

Variable-rate interest products are designed with the aim to fluctuate with the changing market environment. Investors in a variable rate interest product are required to pay an interest rate that is based on an underlying Indexed rate and a margin added to the index rate.

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Now the combination of these two components results in the borrower’s fully indexed rate. Thus, lenders can index the underlying Indexed rate to different benchmarks with the most common being their prime rate or a U.S. Treasury rate.

Lenders on the other hand also set a margin in the underwriting process, depending on the borrower’s credit profile. Note that a borrower’s fully indexed interest rate will change as the underlying indexed rate fluctuates.

How Much Does Rate Cap Cost?

Cap cost is known as premium. The premium for an Interest Rate Cap is based on the cap rate a borrower wants to achieve when compared to current market interest rates. The premium for an Interest Cap is also dependent on the rollover frequency and how you make your premium payments.

Over What Period can a Cap be Obtained?

The period over which an interest rate cap can be purchased can be for a minimum term of 90 days and a maximum term of five years. Once the actual interest rate rises above the cap strike rate, the bank will reimburse the extra interest to the customer.

If my Loan is RepaidEarly can the Cap be Cancelled?

Interest caps are very separate from your loan facility. If at any time you repay these borrowings, you can either let the cap run to maturity or it may be terminated. Note that based on interest rate movements, there may be some remaining value of the cap. The bank will pay this remaining value to you on termination.

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Information Required

Once you decide you can benefit from an interest cap, you will have to sign the bank’s standard terms and conditions. These documents are easy to read and understand. They summarize the terms and conditions under which you have agreed to deal with the bank.

Limitations of an Interest Rate Cap

This limitations may depend on the product that a borrower decides on while entering into a mortgage plan. Where the interest rates are rising, the rate will adjust higher, and the borrower would have been better off originally entering into a fixed-rate loan.

Even though caps restrict the percentage increase, the rates on the loan still increase in a rising rate environment. This implies that borrowers must be able to afford the worst-case scenarios rate on the loan if the rates significantly increase.

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