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Capped rates are variable interest rates with a limit that they cannot exceed, commonly found in mortgages and floating rate notes. While they offer protection against rising rates, they often come with high fees and may be less competitive than fixed rates. They are linked to a particular rate but cannot exceed the limit, and are different from conversion options. Capped rate mortgages are rare, while floating rate limit bonds and notes with floors are more common. While they can be attractive to risk takers, they may be less profitable than traditional products if rates remain constant or increase.
A capped rate is a variable interest rate that can fluctuate over time, but has a cap or limit that it cannot exceed. Some examples of these financial instruments are a capped rate mortgage and a capped floating rate note. At first, capped rates appear to be a win-win product because the borrower will pay the market rate if rates fall, while protecting themselves against a capped interest rate if rates rise. A closer look shows that most capped rate products have a commission and spread and over time may be less competitive than a fixed interest rate.
Traditionally, interest rates can be fixed or variable. In the United States, these rates are usually set by the Federal Fund Rate. Elsewhere they may be linked to an offered interbank rate such as the London Interbank Offered Rate (LIBOR) or the Tokyo Interbank Offered Rate (TIBOR). A capped fare will also be linked to a particular fare, but cannot exceed the limit; once the market rate falls below the limit, the borrower will once again pay the market rate. This is different from financial instruments with a conversion option, which start with a floating rate but can become permanently fixed if the option is exercised.
Here is an example of a 30-year top rate mortgage held in the United States. The interest rate varies just like an adjustable rate mortgage, but is capped at 6.75%. Otherwise, the borrower agrees to pay the federal fund rate plus 0.5 percent. If the current floating rate is 5.0 percent, the borrower will pay 5.5 percent. If the variable rate exceeds 6.25%, the borrower will only pay the maximum rate of 6.75%.
Top rate mortgages are rare. Floating rate limit bonds are more common, as are floating rate notes with floors. They pay interest that fluctuates but have a fixed high or low, respectively. Capped rates are also common features of more complex derivative financial instruments.
Products that have limited fees can be very attractive to prudent risk takers. The floating rate allows for financial opportunity if interest rates go down. The limit provides some stability and protection from interest rate volatility.
On the other hand, if rates remain constant or increase, capped rates are less attractive than other products. Often the security of capped rates must be purchased with high fees. Also, the spread or increase in classic floating rates can add up over the years. Cut-rate products may prove to be less profitable than traditional products.
Smart Asset.
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