Interest Rate Cap Structure: Definition, Uses, and Examples

What Is an Interest Rate Cap Structure?

An interest rate cap structure refers to the provisions governing interest rate increases on variable-rate credit products. An interest rate cap is a limit on how high an interest rate can rise on variable-rate debt. Interest rate caps can be instituted across all types of variable rate products.

However, interest rate caps are commonly used in variable-rate mortgages and specifically adjustable-rate mortgage (ARM) loans.

How Interest Rate Caps Work

Interest rate cap structures serve to benefit the borrower in a rising interest rate environment. The caps can also make variable rate interest products more attractive and financially viable for customers.

Variable Rate Interest

Lenders can offer a wide range of variable rate interest products. These products are most profitable for lenders when rates are rising and most attractive for borrowers when rates are falling.

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

The combination of these two components results in the borrower’s fully indexed rate. Lenders can index the underlying indexed rate to various benchmarks with the most common being their prime rate or a U.S. Treasury rate.

How Interest Rate Caps Can Be Structured

Interest rate caps can take various forms. Lenders have some flexibility in customizing how an interest rate cap might be structured. There can be an overall limit on the interest for the loan. The limit is an interest rate that your loan can never exceed, meaning that no matter how much interest rates rise over the life of the loan, the loan rate will never exceed the predetermined rate limit.

Interest rate caps can also be structured to limit incremental increases in the rate of a loan. An adjustable-rate mortgage (ARM) has a period in which the rate can readjust and increase if mortgage rates rise.

The ARM rate might be set to an index rate plus a few percentage points added by the lender. The interest rate cap structure limits how much a borrower's rate can readjust or move higher during the adjustment period. In other words, the product limits the number of interest rate percentage points the ARM can move higher.

Example of an Interest Rate Cap Structure

Adjustable-rate mortgages have many variations of interest rate cap structures. For example, let's say a borrower is considering a 5-1 ARM, which requires a fixed interest rate for five years followed by a variable interest rate afterward, which resets every 12 months.

With this mortgage product, the borrower is offered a 2-2-5 interest rate cap structure. The interest rate cap structure is broken down as follows:

• The first number refers to the initial incremental increase cap after the fixed-rate period expires. In other words, 2% is the maximum the rate can increase after the fixed-rate period ends in five years. If the fixed-rate was set at 3.5%, the cap on the rate would be 5.5% after the end of the five-year period.
• The second number is a periodic 12-month incremental increase cap meaning that after the five year period has expired, the rate will adjust to current market rates once per year. In this example, the ARM would have a 2% limit for that adjustment. It's quite common that the periodic cap can be identical to the initial cap.
• The third number is the lifetime cap, setting the maximum interest rate ceiling. In this example, the five represents the maximum interest rate increases on the mortgage.

So let's say the fixed rate was 3.5% and the rate was adjusted higher by 2% during the initial incremental increase to a rate of 5.5%. After 12 months, mortgage rates rose to 8%, the loan rate would be adjusted to 7.5% because of the 2% cap for the annual adjustment.

If rates increased by another 2%, the loan would only increase by 1% to 8.5%, because the lifetime cap is five percentage points above the original fixed rate.

Periodic Interest Rate Cap

A periodic interest rate cap refers to the maximum interest rate adjustment allowed during a particular period of an adjustable-rate loan or mortgage.

The periodic rate cap protects the borrower by limiting how much an adjustable-rate mortgage (ARM) product may change or adjust during any single interval. The periodic interest rate cap is just one component of the overall interest rate cap structure.

Limitations of an Interest Rate Cap

The limitations of an interest rate cap structure can depend on the product that a borrower chooses when entering into a mortgage or loan. If interest rates are rising, the rate will adjust higher, and the borrower might have been better off originally entering into a fixed-rate loan.

Although the cap limits the percentage increase, the rates on the loan still increase in a rising rate environment. In other words, borrowers must be able to afford the worst-case scenario rate on the loan if rates rise significantly.

The Bottom Line

Understanding how interest rates caps work with different types of mortgages can help determine with mortgage can best fit your needs. For more specific guidance on your options, consider consulting a professional financial advisor.