Interest Rate Caps: A Simple Solution for Rate Protection

I recently attended Brad Sumrok’s Rat Race 2 Retirement Apartment Syndication meeting in Dallas. If you’re wanting to get started investing in real estate syndications, being around other like-minded people is a great way to jumpstart your success.

In case you missed it, here’s my interview with Brad:

One of the investment terms he mentioned that was important when it comes to risk management involving apartment investing is something called the interest rate cap

If you’re not familiar with it, then this article should fill you in…

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What Is An Interest Rate Cap?

An interest rate cap (aka cap) is a risk management tool that limits how much a variable interest rate can change over a set period of time. This should not be confused with a cap rate which is a totally different metric in which I go into great detail HERE.

An interest rate cap essentially serves as an insurance policy for both the property owner and lender against potential increases in interest rates by “locking in” a maximum loan interest rate. 

It gives borrowers the security of a cap on interest rates while still maintaining the opportunity to benefit from possible interest-rate declines in exchange for an up-front premium. 

A floating interest rate (variable rate) can change during the life of the loan. This is unlike a fixed interest rate which tends to remain consistent.

If you’re a homeowner, it’s likely you’ve taken out a home loan that’s either a 15 or 30 year fixed rate which means it’ll remain the same over the course of the loan (unless of course you refinance). 

Since an increase in a loan’s interest rate will likewise increase the payment due, a cap can prevent an unaffordable increase in the payment. 

What Determines The Cost Of The Cap Interest Rate?

Typically for any given interest rate environment, the interest rate cap payment is driven by three variables:

#1. Notional

The notional amount is the cap size or the dollar amount covered by the cap. This amount typically equates to the loan amount. 

Generally, a cap with a larger notional is more expensive than one with a smaller notional.

#2. Term

The term is the cap’s duration which is the length of time it’s protecting the borrower. As you can imagine, the longer the term, the higher the cap price. 

Pricing doesn’t linearly increase with the term. For instance, the third year of a cap is often more expensive than the first two years combined.

#3. Strike rate

The strike rate (strike price) is the interest rate at which the cap provider begins to make payments to the cap purchaser. In other words, anything above this rate level will provide a financial benefit to the borrower.

Lower strike caps are more expensive as it’s more likely that the cap provider will need to make a payment during the term of the cap.

How Interest Rate Caps Can Be Structured

Interest rate caps are usually taken out for periods of two to five years and hedge risk to both parties involved (lender and borrower) against market fluctuations by adding a third party (cap provider) to the equation.

This third party will guarantee they will make any interest payments over the strike rate thus protecting the borrower and lender from a tremendous rise in rates.

This provides 2 things:

a. Makes the lender feel confident the payments will never be missed even if interest rates increase dramatically.

b. Provides some peace of mind to the borrower knowing that they won’t have to worry about paying exorbitant interest payments if rates go up.

An interest rate cap can be structured differently as lenders have flexibility in customizing them.

#1. Overall limit

Lenders may choose to set up an overall interest rate limit that the loan can never exceed.

This means that no matter how much interest rates rise over the life of the loan, the loan rate will never exceed the predetermined rate limit.

#2. Incremental limit increases

Rate caps can also be structured to limit incremental increases in the loan’s interest rate.

An example of this is floating rate loan or adjustable-rate mortgage (ARM). These have a period in which the rate can readjust and increase if mortgage rates rise.

Let’s look at these in more detail….

Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage (ARM) is a loan instrument that carries a cap without a fixed interest rate.

Throughout the duration of the loan, the interest rate can change based on movements in an index rate, such as a certain Treasury securities or cost of funds index.

3 Types of caps

The adjustable rate mortgage typically include 3 types of caps that control how the interest rate can adjust:

#1. Initial adjustment cap

This determines how much the rate can increase the first time it moves after the fixed-rate expires. It typically ranges from 2-5%.

In other words, the new rate can’t be 2-5 percentage points higher than the initial rate during the fixed-rate period after the first time it changes.

#2. Subsequent adjustment cap

This particular cap refers to how much the interest rate can increase in the periods of adjustment that follow. It’s commonly set at 2% which means the new rate can’t be more than two percentage points higher than the previous rate.

#3. Lifetime adjustment cap

The third cap is the lifetime adjustment cap which sets the maximum interest rate ceiling. In other words, it’s how much the rate can increase throughout the life of the loan.

Most of the time it’s 5%. This means the rate can’t be five percentage points higher compared to the initial rate.

Periodic Interest Rate Cap vs Interest Rate Cap

The maximum rate adjustment allowed during a particular period of an adjustable-rate loan or mortgage loan is the periodic interest rate cap.

This cap protects the borrower by limiting how much an ARM may change during any single interval. 

Bottom Line

An interest rate cap is a risk management tool for consumers that limits how much a variable interest rate can change over a set period of time. 

There is no one specific type of cap, and the type of caps you’ll encounter can vary depending on the specific lending product. 

ARMs frequently feature an initial adjustment cap, a subsequent or periodic adjustment cap, and a lifetime adjustment cap. 

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