Interest paid on loans is the charges a borrower pays for using the money of the lender. So when it comes to paying the interests, as a borrower, you would want to do the maths first and then structure your loans accordingly. There are numerous mortgage loans offered with variable interest rates that change according to the base index being followed. To protect the borrower in case of unusual changes in the index, an interest rate cap is imposed.
An interest rate cap structure is a structure designed to govern the interest rates on the variable rate credit instruments. It imposes a limit on how high the interest rate can rise on a credit instrument with variable interest rates. These are most commonly used in long-term mortgage loans to prevent any dramatic change in the rates if the rates are floating.
Loans with floating rates are an attractive loan option for borrowers. These loans are most profitable for the lenders when the interest rates are rising and borrowers find them most attractive when the rates are falling. These are designed to keep up the pace with the changing market environment.
The interest rate for these loans is determined based on an underlying index that the lender prefers upon which they add their own margin. Facilitating a rate cap on the loans adds a layer of assurance for the borrowers in case of an unlikely price rise, making them more attractive.
Some key features and structuring of the interest rate caps are:
Lenders can choose to bend the rate caps to some extent. They can choose to put an overall rate cap on the limit of the interest rates. This means that the interest rate cannot go beyond a predetermined rate for the entirety of the loan period.
Another way is to fix a percentage on the incremental increase. For loans such as adjustable rate mortgages, usually, a limit is set on the incremental increase. This sets a limit on how much the interest rate can be increased in an adjustment period.
Even though the interest rate caps can protect the borrower up to a certain increase in the case of an unlikely rise in the market, it can still turn out to be of little help. In the scenario of a rising market, the borrower might have been better off with a fixed-rate loan. Therefore a borrower must be prepared for the worst-case scenario while opting for a floating rate loan.
