An interest rate cap is a term that denotes the upper limit or the maximum amount of interest that a loan lender is permitted to charge on the loans they grant. Typically, interest rate caps are designated for home loans or mortgages where they indicate the maximum rate at which interest can be levied on such home loans or mortgages. Interest rate caps play an active role in protecting prospective home buyers or mortgage borrowers against exceptionally high interest rate jumps during the terms of their home loans. Interest rates tend to change several times over the duration of a loan owing to market index changes. Therefore, interest rate caps are established beforehand to prevent any unforeseen financial burdens on loan borrowers.
It should be noted that interest rate caps are typically most helpful when it comes to adjustable-rate mortgages. Before we go on, let us first understand the concept of adjustable-rate mortgages. Ordinarily, a mortgage or a home loan is acquired from lending institutions, and under the purview of such mortgages, the borrowers promise to return the loan with added interest. Now, the rate at which this interest is charged on the loans may vary.
Under the provisions of an adjustable-rate mortgage, the borrower acquires a home loan from a financial institution and promises to pay interest at an adjustable rate. This essentially means that the interest rates on these loans are subject to periodic adjustments. These adjustments may depend largely on market conditions. They may even be evaluated and assessed by the lending institutions exclusively. It should be noted here that such loans may prove disadvantageous and highly risky for the borrowers.
Under the domain of real estate, interest rate caps can be explained with special reference to adjustable-rate mortgages. It should be recognized that interest rate caps find no application when it comes to fixed-rate mortgages. This is quite self-explanatory owing to the fact that fixed-rate mortgages have the same rates of interest throughout the loan terms.
The principal objective behind the employment of interest rate caps is to safeguard the borrowers of home loans from unanticipated expenses which may result from sudden intense increments of interest rates.
Interest rate caps are said to be the opposite of interest rate floors whereas interest rate floors denote the lowest amount of interest that can be charged on a loan. Both of these derivatives effectively allow lenders and borrowers of loans to avoid the risks associated with interest rate fluctuations.
