An interest rate cap structure outlines how high your interest rate can rise on a variable-rate loan product. It also determines how quickly your rate can increase over time.
Interest rate caps protect you from sudden interest rate hikes and limit the total amount you can pay in interest. When you understand how the interest rate cap structure works, you'll know what to look for in a variable-rate lending product.
Definition and Examples of an Interest Rate Cap Structure
An interest rate cap is a feature of a loan that limits how much your interest can rise on a variable-rate loan product. As a borrower, it protects you from paying excessively high interest rates.
When you take out a variable-rate lending product, the rate cap lets you lock in a maximum interest rate on the loan.
A common example of an interest rate cap in action is the adjustable-rate mortgage (ARM). If you apply for a 5/1 ARM, your interest rate will be fixed for the first five years of the loan. After that, the interest rate will rise or fall once a year for the life of the loan. Whether your rate rises or falls will depend on what’s going on in the market. But thanks to the interest rate cap structure, you’ll know that your rate will never rise past a certain point.
How Does an Interest Rate Cap Structure Work?
When you take out a variable-rate loan product, your interest rate will go up and down, depending on the market. Your interest rate cap protects you from extreme rate hikes by capping your interest rate annually or over the life of the loan.
An annual interest rate cap determines how much your interest rate can go up within a given year. In comparison, a life-of-the-loan cap sets the maximum interest rate you’ll pay while you hold the mortgage.
Let’s say you take out a 5/1 ARM with an initial fixed rate of 3% and a 2/2/6 cap rate structure. For the first five years of the mortgage, you’ll have a low fixed interest rate and the cap doesn’t apply. Once your rate adjusts during the sixth year, the cap kicks in and limits yearly rate increases to 2%. The lifetime adjustment cap is set at 6%.
So using the above example, your interest rate will be 3% for the first five years. During the sixth year of your mortgage, your interest rate can only go as high as 5%. And then, during the seventh year, your interest rate can only go as high as 7%. However, because the loan’s lifetime cap rate is 6 percentage points, your rate cannot rise above 9% over the life of the loan.
Types of Interest Rate Caps
When you take out an ARM, three different interest rate caps control how much your interest rate can rise and fall.
Initial Cap
Your initial cap determines how much your interest rate can rise the first time after the initial fixed-rate period ends. The initial cap is typically 2 percentage points or 5 percentage points.
Subsequent Cap
The subsequent cap determines how much your interest rate can adjust in the years following the initial adjustment cap. The subsequent cap is usually set at 2 percentage points higher.
Lifetime Cap
The lifetime cap is the maximum percentage your interest rate can rise over the life of the loan. It’s commonly set at 5%, which means your rate can never go more than 5 percentage points higher than your initial rate.
When you’re comparing ARM offers from different lenders, check to see what the percentages are for the various rate caps. Even if the initial interest rates are the same, you want to look for a lender that offers a low initial, subsequent, and lifetime rate cap.
Interest Rate Cap vs. Interest Rate Floor
Interest Rate Cap | Interest Rate Floor | |
Determines how high your interest rate can rise on a variable loan product | Determines the lowest possible interest rate you can receive on a variable loan product | |
Protects the borrowers from extreme rate hikes | Protects the lender or investor from losing money |
When you apply for a variable loan product, your lender will set an interest rate cap and may include an interest rate floor. Your interest rate floor is the lowest possible rate you can receive over the life of the loan.
Just like the interest rate cap protects you from skyrocketing interest rates, the interest rate floor protects your lender from losing money on the loan via lower-than-expected interest rates.
Key Takeaways
- The interest rate cap structure determines how much your interest rate can rise on a variable-rate lending product.
- The interest rate cap can specify the maximum interest rate annually and over the life of the loan.
- There are three different types of interest rate caps: the initial cap, subsequent cap, and lifetime cap.
- In comparison, the interest rate floor is the lowest possible rate you can receive on a variable loan product.