Interest Rate Caps: What Are They And How Do They Work?

An interest rate cap sets the limit on how high an interest rate can rise. As a borrower with a variable-rate loan, understanding how this cap impacts your loan can have a major impact on your financial plans.

What Is An Interest Rate Cap?

An interest rate cap limits how much the interest rate attached to a variable-rate loan product can rise. As a homeowner, interest rate caps come into play if you opt for an adjustable-rate mortgage (ARM).

Depending on the specifics, an interest rate cap can include an overall limit for how high the interest rate can rise and limit how much the interest rate can adjust during adjustment periods. In either situation, an interest rate cap protects the borrower from unrealistic interest rate increases.

Importantly, a cap rate is different from an interest rate cap. Cap rates are used by real estate investors when evaluating the financial viability of a property.

Interest Rate Caps Vs. Interest Rate Floors

Interest rate caps represent a maximum interest rate. In contrast, an interest rate floor indicates how low a variable rate can fall. In uncertain economic times, market rates can exhibit extreme volatility. With that, interest rate caps and interest rate floors protect both the borrower and the lender from unrealistic rates.