Interest Rate Caps: Definition, Example, Usage

In the financial world, many different terms may be unfamiliar to you. One of these could be an “Interest Rate Cap,” which can help you protect your investments or savings from any drastic changes in interest rates.

Interest rate caps have been around for over 50 years and have proven to be an effective way for investors to minimize risk while maximizing their potential return on investment. In this blog post, we will break down what an interest rate cap is and how it can work for you.

What is an Interest Rate Cap

Interest rate caps are one of many types of options you can put on investments or savings that have a variable interest rate. The most common products that have a variable interest rate are certificates of deposit (CDs), adjustable-rate mortgages, bond funds, and individual bonds.

By purchasing a cap option, the buyer is protected from any increases in the underlying interest rate. If interest rates increase and exceed a certain pre-determined level (cap), the buyer only pays the cap-level interests. For example, if you purchased a five-year adjustable-rate mortgage (ARM) with an interest rate cap of 3% above the initial rate of 2%, then your maximum payable interest rate is capped at 5%.

In the above example, you own an interest option that pays off if the interest rate rises above the cap level. This option is also called an embedded derivative. It is the exact opposite of the interest rate floor which we have discussed before in this blog.

How do Interest Rate Caps Work

You can purchase an interest rate cap for a specific time frame and a certain pre-determined percentage. The cap option will protect you from any increase in interest rate. To enjoy the protection provided by the interest rate cap, you will have, however, to pay a premium upfront.

For example, you purchase an interest rate cap for five years and set your cap at 2% above your initial rate for this time. If the interest rate increases above the cap level, your payoff will be the difference between the interest rate and the cap level. This means that if you own an adjustable-rate mortgage (ARM), the interest rate cap will prevent your mortgage rate from rising above the cap level.

What are some benefits of Interest Rate Caps

An interest rate cap brings a lot of benefits to an investor. Here are a few of the most common benefits of an interest rate cap:

  • Protects from rising interest rates
  • You are rewarded for the difference between the current interest rate and your original rate
  • Helps better manage potential risks
  • Helps to adjust a floating rate for a certain time

Conclusion

Interest rate caps have been around for a long time and can be an effective tool for managing interest rate risks. From adjusting a fixed return rate for a certain period to protecting yourself from rising interest rates, this financial tool can be a good addition to your financial toolbox.

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