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 possible rate a borrower may have to pay and also 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 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 are willing to offer. The spread or margin is based on a borrower’s credit profile and determined by the underwriter.

If a product has a capped rate, then 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 level of 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 wish to structure a variable rate bond offering with an interest rate cap. An interest rate cap serves to benefit the bond issuer because it helps to limit 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, then the cap could adversely affect the secondary market price when the cap is reached, decreasing the 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 also 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. Limiting the interest base level, however, 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.

How Is Interest Rate Cap Determined?

Rate cap pricing can be determined by a number of factors, including:

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

There are also different rate cap structures lenders can apply. With adjustable-rate mortgages, for instance, lenders use any of the following:

• Initial adjustment cap. This cap structure determines how much the interest on an ARM can increase the first time it adjusts after the fixed-rate period ends. It's often capped at 2% or 5%.
• Subsequent adjustment cap. This cap structure specifies how much a loan's interest rate can increase following the initial adjustment period. Again, 2% is a common threshold for this rate cap structure.
• Lifetime adjustment cap. Finally, this rate cap dictates how much the interest rate can increase in total, over the life of the loan. This often maxes out at 5%.

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

• Constant Maturity Treasury (CMT) index (weekly average yield of U.S. Treasury securities, adjusted to a constant maturity of one year)
• 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.