An interest rate cap acts like insurance against high interest rates.
Caps are typically purchased by borrowers with floating rate loans, to protect against the possibility of the floating rate rising above a chosen maximum, the cap rate.
The cap buyer pays a premium for the cap in exchange for extra income whenever the floating rate is higher than the cap rate. The further that the floating rate exceeds the cap rate, the greater the extra income from the cap. The cap income offsets the higher interest cost of the floating rate loan.
When the floating rate is lower than the cap rate, the borrower receives no income from the cap but simply pays the lower floating rate.
Borrowers owning interest rate caps have less risk of being unable to meet loan payments when interest rates rise and are correspondingly better placed to pass lenders’ affordability assessments.
Unlike swaps or fixed rate loans, caps do not expose borrowers to the risks of adverse floors. The risk of a cap is that the buyer pays a premium for the cap but receives nothing in return, for example if interest rates remain below the cap rate for the duration of the instrument.
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