Cap

What is a cap?

A cap, also referred to as an interest rate cap, is a risk management tool that provides protection against increasing interest rates while maintaining the ability to participate in favorable rate movements.

It is an agreement between a buyer and a financial institution such as a bank to receive compensation if the reference rate moves beyond an agreed level, known as the strike rate. One major type of loan that uses interest rate caps is an adjustable rate mortgage, or ARM.

Deeper definition

A cap is a consumer protection that limits the amount that an interest rate can change in an adjustment interval or over the term of the loan.

For instance, if the per-period cap is 1 percent and the current rate is 7 percent, the newly adjusted interest rate cannot go below 6 percent or higher than 8 percent.

One popular loan instrument that carries a cap is an ARM.

An ARM is a type of mortgage that doesn’t come with a fixed interest rate. The rate changes throughout the duration of the loan based on movements in an index rate, such as the cost of funds index or the interest rate on certain Treasury securities.

ARMs typically include several types of caps that control how the interest rate can adjust. There are three types of caps:

• The initial adjustment cap determines how much the rate can increase the first time it moves after the fixed-rate expires. This type of cap typically ranges from 2 percent to 5 percent. This means that the first time it changes, the new rate cannot be two to five percentage points (depending on the actual cap) greater than the initial rate during the fixed-rate period.
• Subsequent adjustment caps refer to how much the interest rate can increase in the periods of adjustment that follow. This cap is commonly 2 percent, so the new rate cannot be more than two percentage points higher than the previous rate.
• The lifetime adjustment cap refers to how much the rate can increase in total, throughout the life of the loan. It is most commonly 5 percent, so the rate cannot be five percentage points higher compared to the initial rate. However, some lending institutions may have higher caps.

In addition to interest rate caps, many adjustable-rate mortgages, including payment-option ARMs, cap or limit how much the monthly payment can increase every adjustment period.

For instance, if the loan has a payment cap of 7.5 percent, the monthly payment will not increase more than 7.5 percent over the previous payment, even if interest rates increase more.

Cap example

For example, a borrower who is paying the Libor rate on a loan can protect himself against a rise in rates by buying a cap at 2.5 percent. If the interest rate exceeds 2.5 percent in a given payment period, the payment won’t move higher that the 2.5 percent cap.

The first benefit of a cap is flexibility. It allows buyers to tailor their caps based on their interest rate views, hedging and cash-flow requirements.

Another benefit is certainty. Buyers can manage their interest rate exposure when they lock in a strike rate as a hedge against the unsettled balance up to the pre-agreed strike rate.

Want to know about adjustable-rate mortgages? Read this story from Bankrate.com.