What is a Cap?
In finance, a cap is a limit on the interest rate on a floating-rate loan, typically a bond or mortgage, used as a protection against rising interest rates. It sets a maximum interest rate that the borrower will have to pay, regardless of how high market rates climb.
Types of Caps
- Interest Rate Cap
- Life Cap
- Periodic Rate Cap
Examples of Caps
For example, if you have a mortgage loan with a 5% interest rate cap, even if the market rate goes up to 7%, you will still only pay 5% interest on your loan.
Case Studies
One common use of caps is in adjustable-rate mortgages (ARMs), where borrowers are protected from sudden increases in interest rates. This can make homeownership more affordable for many people.
Statistics
According to a study by the Federal Reserve, caps have been effective in reducing the risk of default for borrowers with ARMs, making them a popular choice for many homebuyers.
