Definition
A cap is a limit placed on the amount that an interest rate or other charge can increase. For example, an interest-rate cap sets a maximum interest rate that can be charged on a loan, irrespective of the prevailing general interest-rate levels. This protects borrowers from significant increases in their interest payments.
Lenders often charge a fee at the outset of the loan for including a cap. This fee compensates lenders for the potential reduction in interest income due to the cap. Caps may also limit annual increases to a specific level, providing further predictability for borrowers.
Examples
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Interest Rate Cap on Adjustable-Rate Mortgage (ARM): A borrower takes an adjustable-rate mortgage (ARM) with an interest-rate cap of 5%. This means that no matter how high the market interest rate rises, the borrower’s interest will not exceed 5%.
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Annual Increase Cap: A borrower has a loan with an interest rate that can change annually based on market rates, but an annual increase cap of 1%. Even if market rates go up by 2%, the loan interest rate will only increase by a maximum of 1% for that year.
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Credit Card Interest Rate Cap: A credit card company offers a cap on interest rates at 20%. This means that the credit card interest rate will not surpass 20% regardless of economic conditions.
Frequently Asked Questions (FAQs)
What is the purpose of an interest-rate cap?
An interest-rate cap is designed to protect borrowers from sharp increases in interest rates, making future repayment amounts more predictable and manageable.
How does a lender compensate for the risk associated with a cap?
Lenders typically charge an upfront fee at the outset of the loan to offset the risk associated with including an interest-rate cap.
Are rate caps only applicable to loans?
No, rate caps can also apply to credit cards and other financial products where interest rates are involved.
Can the cap limit both annual and lifetime interest rate increases?
Yes, caps can be structured to limit both annual increases and overall lifetime increases in interest rates.
Do all adjustable-rate loans have caps?
Not necessarily. While many adjustable-rate loans include caps, some do not, leaving borrowers vulnerable to significant changes in interest rates.
What’s the difference between a cap and a floor?
A cap limits the maximum interest rate or charge, while a floor sets a minimum interest rate or charge. Both terms can be used to create collars, which define a range within which the rate or charge can fluctuate.
How are caps related to collars?
A collar is a combination of a cap and a floor, setting both upper and lower limits on rates or charges, thus defining a range of possible interest rate fluctuations.
What happens if market rates exceed the cap?
If market rates exceed the cap, the borrower’s interest rate remains at the capped level, protecting them from the increase.
Do borrowers have a choice in opting for a cap?
Often, borrowers can choose whether or not to include a cap in their loan agreement when negotiating terms with the lender.
Why might a borrower seek a loan with a cap?
Borrowers might seek a loan with a cap to mitigate the risk of rising interest rates and ensure more stable monthly payments over time.
Related Terms
Floor: A minimum interest rate or charge that can be applied, often used in conjunction with a cap to form a collar.
Collar: An agreement in financial contracts that sets both a cap (maximum limit) and a floor (minimum limit) on interest rates or charges, creating a range within which the rates or charges can vary.
Online References
For more information, you can refer to:
- Investopedia - Understanding Loan Caps and Collars
- The Balance - How an Interest Rate Cap Works
- Nerdwallet - The Basics of Adjustable-Rate Mortgages
Suggested Books for Further Studies
- “Interest Rate Swaps and Other Derivatives” by Howard Corb
- “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman and Angel Serrat
- “The Handbook of Fixed Income Securities” by Frank J. Fabozzi
Accounting Basics: “Cap” Fundamentals Quiz
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