Interest Rate Cap

An interest rate cap is a financial derivative that is used to protect borrowers against rising interest rates on floating-rate loans. It limits the maximum amount of interest that a borrower will have to pay on a loan. Lenders also benefit from interest rate caps because they can set a rate threshold that helps to ensure that borrowers can afford their interest payments, reducing the risk of default in a rising interest rate environment. A floating-rate loan's interest expense is calculated by adding a spread (an additional interest rate charged by the lender) to a benchmark index, such as the Secured Overnight Financing Rate (SOFR) or the Wall Street Prime Rate. If the benchmark index increases, the borrower's interest payments will also increase unless they have an interest rate cap in place. An interest rate cap is purchased upfront and can be financed as part of a development project or business plan. It has several components, including the rate cap size (which typically matches the total loan amount), the rate cap duration (which may be required to be the same as the loan term), the strike price (the specified rate threshold at which the cap is triggered), and the level of interest rate volatility. When purchasing an interest rate cap, borrowers should consider the cost of the cap, which will depend on these factors, as well as the potential savings from having the cap in place. Interest rate caps are offered by financial institutions and can be underwritten in the same way as a loan.

Interest rate caps can be used to protect investors by limiting the maximum amount of interest that a borrower will have to pay on a floating-rate loan. This can help to ensure that the borrower has enough cash flow to service the loan and make regular interest payments to the investors. In a rising interest rate environment, the use of an interest rate cap can help to reduce the risk of default on the loan and protect the investors' capital. For example, if an investor provides a loan to a borrower with a floating-rate interest rate and the borrower purchases an interest rate cap, the cap will limit the maximum amount of interest that the borrower has to pay. This can help to ensure that the borrower has sufficient cash flow to make the required interest payments to the investor, even if the benchmark index increases. In this way, an interest rate cap can provide an extra layer of protection for the investor and help to reduce the risk of default on the loan.