Capped rates are variable interest rates with a cap that cannot be exceeded, commonly found in mortgages and floating rate notes. They can offer stability and protection but may be less competitive than fixed interest rates over time.
A capped rate is a variable interest rate that can fluctuate over time, but has a cap or cap that you cannot exceed. Some examples of these financial instruments are a limited rate mortgage and a limited floating rate note. At first, rate caps seem like a win-win product because the borrower will pay the market rate if rates fall while protecting themselves with rate caps if rates rise. A closer look shows that most rate-capped products have a fee 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 generally set by the Federal Fund rate. Elsewhere, they may be tied to an interbank offered rate, such as the London Interbank Offered Rate (LIBOR) or the Tokyo Interbank Offered Rate (TIBOR). A capped rate will also be tied to a certain rate, but cannot exceed the cap; Once the market rate falls below the limit, the borrower will pay the market rate again. This is different from financial instruments with a conversion option, which start with a variable rate but can be permanently fixed if the option is exercised.
Here is an example of a 30-year rate cap mortgage held in the United States. The interest rate varies like an adjustable-rate mortgage, but is capped at 6.75 percent. Otherwise, the borrower agrees to pay the Federal Fund rate plus 0.5 percent. If the current adjustable rate is 5.0 percent, the borrower will pay 5.5 percent. If the adjustable rate exceeds 6.25 percent, the borrower will pay only the capped rate of 6.75 percent.
Top rate mortgages are rare. Capped floating rate bonds are more common, as are floating rate notes. They pay interest payments that fluctuate but have a fixed maximum or minimum, respectively. Capped rates are also common features of more complex derivative financial instruments.
Products that have limited rates can be very attractive to the cautious risk taker. The variable rate allows for financial opportunities if interest rates fall. The cap provides some stability and protection against volatile interest rates.
On the other hand, if rates remain constant or increase, capped rates are less beneficial than other products. Often, rate cap security must be purchased at high rates. In addition, the spread or increase in classic variable rates can add up over the years. Rate-limited products may be less lucrative than traditional products.
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