What is an Interest Rate Cap?
An interest rate cap is a derivative in which the buyer receives payments at the end of each period when the interest rate exceeds the agreed strike price. It provides insurance against rising interest rates.
How Rate Caps Work
- You pay an upfront premium to purchase the cap
- If interest rates rise above the cap rate, you receive payments
- If rates stay below the cap, you receive no payments
- The cap effectively limits your interest rate exposure
Benefits of Interest Rate Caps
- Upside protection: Limits exposure to rising rates
- Known maximum cost: Upfront premium is the only cost
- Downside benefit: Benefit from rates staying low
- Balance sheet friendly: Often more favorable accounting
When to Consider an Interest Rate Cap
- Floating-rate loans or credit facilities
- Expected rising interest rate environment
- Need for budget certainty with maximum rates
- Desire to benefit if rates remain low
Note: Interest rate caps require an upfront premium payment. The value of the cap depends on factors including the cap rate, term, underlying index, and market volatility.
