assignment of interest rate cap

That's 'Interest'ing May 2022 - A Primer on Interest Rate Caps

When the interest rate on a mortgage financing is not fixed, the amount that a borrower may be required to pay may fluctuate depending on changes in the underlying index to which the “margin” or “spread” is tied. While a lender may be comfortable with its underwriting of a financing and the ability of its borrower to service its debt at closing, if the underlying index of a floating rate loan changes over time, the lender’s comfort and the ability of its borrower to service its debt will obviously change. To combat against interest rate volatility, borrowers and lenders usually agree to hedge the interest rate against the uncertainty in the market for floating rate loans. The most common form of such hedging is an “interest rate cap.”

An interest rate cap is a derivative whereby the interest rate cap provider (the “counterparty”) agrees to pay the interest which would be payable by the borrower over a strike price (the “strike”) on the notional amount (the principal amount) of the loan. Consequently, if the index of the loan rises above the strike, the counterparty, and not the borrower, is liable for the excess interest payment obligation. In this way, the borrower’s liability for payment of interest on the loan in question is always “capped” at an amount equal to the strike plus the spread.

As additional collateral for a loan, the borrower will purchase an interest rate cap and pledge it to the lender. Simply put, the interest rate cap is an insurance policy on a floating rate loan, which protects the borrower and the lender if the interest rate index rises above the strike during a specified period of time (the “term”). The term of the cap is usually coterminous with the initial term of the loan. If the loan is extended, extensions are usually conditioned on the purchase of a new interest rate cap for the extended period.

Caps are purchased upfront with a single payment at the closing of a loan. After the premium is paid, the borrower has no further payment obligations. Most lenders will require borrowers to purchase the interest rate cap as a condition to closing the loan. Lenders also require that the cap provider have a minimum credit rating from Moody’s, S&P, Fitch or another rating agency. The interest rate cap is usually auctioned to a number of creditworthy financial institutions to secure the most favorable terms at the lowest premium price. Lenders will require the counterparty to maintain a certain rating level during the term. In the event that the counterparty does not maintain its rating, the borrower will typically be required to (i) replace the counterparty with a new counterparty that meets the qualifications and execute a new interest rate protection agreement, (ii) require the counterparty to supply a guaranty from a party meeting the ratings default, or (iii) cause the counterparty to deliver collateral to secure its exposure to the borrower in an amount acceptable to the lender and the rating agencies. In most cases, borrowers will choose either option (i) or (ii).

Since most caps are purchased through an auction process, a bid package is usually assembled for the bidders, which includes the agreed-upon terms of the interest rate cap, the timeline for which the auction must be completed, the assignment of interest rate cap protection agreement, and the form of confirmation. The confirmation describes the particulars of the transaction, such as the loan amount, payment dates, accrual periods and other pertinent dates, the rates, and other material items necessary to understand the parameters of the interest rate cap. It is important to review the confirmation and the bid package to ensure all terms are correct, and accurately reflect the terms of the transaction. At closing, the borrower will collaterally assign the interest rate cap agreement, which is additional collateral for the loan, and ensures the lender’s right to receive payments under the agreement.

While interest rate hedging takes many forms, interest rate caps are the most common derivative in mortgage financing. As we understand the process, we expect the market and traditional requirements to make implementation of this aspect of mortgage financing a smoother and simpler endeavor.

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Interest Rate Cap Structure: Definition, Uses, and Examples

What Is an Interest Rate Cap Structure?

An interest rate cap structure refers to the provisions governing interest rate increases on variable-rate credit products. An interest rate cap is a limit on how high an interest rate can rise on variable-rate debt. Interest rate caps can be instituted across all types of variable rate products.

However, interest rate caps are commonly used in variable-rate mortgages and specifically adjustable-rate mortgage (ARM) loans.

Key Takeaways

• An interest rate cap is a limit on how high an interest rate can rise on variable rate debt. Interest rate caps are commonly used in variable-rate mortgages and specifically adjustable-rate mortgage (ARM) loans.
• Interest rate caps can have an overall limit on the interest for the loan and also be structured to limit incremental increases in the rate of a loan.

Interest rate caps can give borrowers protection against dramatic rate increases and also provide a ceiling for maximum interest rate costs.

How Interest Rate Caps Work

Interest rate cap structures serve to benefit the borrower in a rising interest rate environment. The caps can also make variable rate interest products more attractive and financially viable for customers.

Variable Rate Interest

Lenders can offer a wide range of variable rate interest products. These products are most profitable for lenders when rates are rising and most attractive for borrowers when rates are falling.

Variable-rate interest products are designed to fluctuate with the changing market environment. Investors in a variable rate interest product will pay an interest rate that is based on an underlying indexed rate plus a margin added to the index rate.

The combination of these two components results in the borrower’s fully indexed rate. Lenders can index the underlying indexed rate to various benchmarks with the most common being their prime rate or a U.S. Treasury rate.

Lenders also set a margin in the underwriting process based on the borrower’s credit profile. A borrower’s fully indexed interest rate will change as the underlying indexed rate fluctuates.

How Interest Rate Caps Can Be Structured

Interest rate caps can take various forms. Lenders have some flexibility in customizing how an interest rate cap might be structured. There can be an overall limit on the interest for the loan. The limit is an interest rate that your loan can never exceed, meaning that no matter how much interest rates rise over the life of the loan, the loan rate will never exceed the predetermined rate limit.

Interest rate caps can also be structured to limit incremental increases in the rate of a loan. An adjustable-rate mortgage (ARM) has a period in which the rate can readjust and increase if mortgage rates rise.

The ARM rate might be set to an index rate plus a few percentage points added by the lender. The interest rate cap structure limits how much a borrower's rate can readjust or move higher during the adjustment period. In other words, the product limits the number of interest rate percentage points the ARM can move higher.

Example of an Interest Rate Cap Structure

Adjustable-rate mortgages have many variations of interest rate cap structures. For example, let's say a borrower is considering a 5-1 ARM, which requires a fixed interest rate for five years followed by a variable interest rate afterward, which resets every 12 months.

With this mortgage product, the borrower is offered a 2-2-5 interest rate cap structure. The interest rate cap structure is broken down as follows:

• The first number refers to the initial incremental increase cap after the fixed-rate period expires. In other words, 2% is the maximum the rate can increase after the fixed-rate period ends in five years. If the fixed-rate was set at 3.5%, the cap on the rate would be 5.5% after the end of the five-year period.
• The second number is a periodic 12-month incremental increase cap meaning that after the five year period has expired, the rate will adjust to current market rates once per year. In this example, the ARM would have a 2% limit for that adjustment. It's quite common that the periodic cap can be identical to the initial cap.
• The third number is the lifetime cap, setting the maximum interest rate ceiling . In this example, the five represents the maximum interest rate increases on the mortgage.

So let's say the fixed rate was 3.5% and the rate was adjusted higher by 2% during the initial incremental increase to a rate of 5.5%. After 12 months, mortgage rates rose to 8%, the loan rate would be adjusted to 7.5% because of the 2% cap for the annual adjustment.

If rates increased by another 2%, the loan would only increase by 1% to 8.5%, because the lifetime cap is five percentage points above the original fixed rate.

Periodic Interest Rate Cap

A periodic interest rate cap refers to the maximum interest rate adjustment allowed during a particular period of an adjustable-rate loan or mortgage.

The periodic rate cap protects the borrower by limiting how much an adjustable-rate mortgage (ARM) product may change or adjust during any single interval. The periodic interest rate cap is just one component of the overall interest rate cap structure.

Limitations of an Interest Rate Cap

The limitations of an interest rate cap structure can depend on the product that a borrower chooses when entering into a mortgage or loan. If interest rates are rising, the rate will adjust higher, and the borrower might have been better off originally entering into a fixed-rate loan.

Although the cap limits the percentage increase, the rates on the loan still increase in a rising rate environment. In other words, borrowers must be able to afford the worst-case scenario rate on the loan if rates rise significantly.

What Are the Disadvantages of an Adjustable-Rate Mortgage?

The disadvantages of an adjustable-rate mortgage include the fact if interest rates rise that your monthly payments could increase to a point where you may not be able to afford them. If you cannot make your mortgage payments, your home is at risk of foreclosure.

Can You Pay Off an ARM Early?

Whether you can pay off an adjustable rate mortgage (ARM) early will depend on the terms of your mortgages. Some lenders allow early payoffs with no penalties, while other will charge a fee if you pay off the loan before the terms ends.

Can You Refi Out of an ARM?

You can refinance an adjustable rate mortgage just as you would a traditional mortgage. You will essentially take out a new loan to pay off the original loan so you will have new terms.

The Bottom Line

Understanding how interest rates caps work with different types of mortgages can help determine with mortgage can best fit your needs. For more specific guidance on your options, consider consulting a professional financial advisor.

Consumer Financial Protection Bureau. " What Are Rates Caps? "

The Federal Reserve Board. " Consumer Handbook on Adjustable Rate Mortgages ."

Freddie Mac. " Considering an Adjustable Rate Mortgage? "

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A Primer On Interest Rate Caps

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When the interest rate on a mortgage financing is not fixed, the amount that a borrower may be required to pay may fluctuate depending on changes in the underlying index to which the "margin" or "spread" is tied. While a lender may be comfortable with its underwriting of a financing and the ability of its borrower to service its debt at closing, if the underlying index of a floating rate loan changes over time, the lender's comfort and the ability of its borrower to service its debt will obviously change. To combat against interest rate volatility, borrowers and lenders usually agree to hedge the interest rate against the uncertainty in the market for floating rate loans. The most common form of such hedging is an "interest rate cap."

An interest rate cap is a derivative whereby the interest rate cap provider (the "counterparty") agrees to pay the interest which would be payable by the borrower over a strike price (the "strike") on the notional amount (the principal amount) of the loan. Consequently, if the index of the loan rises above the strike, the counterparty, and not the borrower, is liable for the excess interest payment obligation. In this way, the borrower's liability for payment of interest on the loan in question is always "capped" at an amount equal to the strike plus the spread.

As additional collateral for a loan, the borrower will purchase an interest rate cap and pledge it to the lender. Simply put, the interest rate cap is an insurance policy on a floating rate loan, which protects the borrower and the lender if the interest rate index rises above the strike during a specified period of time (the "term"). The term of the cap is usually coterminous with the initial term of the loan. If the loan is extended, extensions are usually conditioned on the purchase of a new interest rate cap for the extended period.

Caps are purchased upfront with a single payment at the closing of a loan. After the premium is paid, the borrower has no further payment obligations. Most lenders will require borrowers to purchase the interest rate cap as a condition to closing the loan. Lenders also require that the cap provider have a minimum credit rating from Moody's, S&P, Fitch or another rating agency. The interest rate cap is usually auctioned to a number of creditworthy financial institutions to secure the most favorable terms at the lowest premium price. Lenders will require the counterparty to maintain a certain rating level during the term. In the event that the counterparty does not maintain its rating, the borrower will typically be required to (i) replace the counterparty with a new counterparty that meets the qualifications and execute a new interest rate protection agreement, (ii) require the counterparty to supply a guaranty from a party meeting the ratings default, or (iii) cause the counterparty to deliver collateral to secure its exposure to the borrower in an amount acceptable to the lender and the rating agencies. In most cases, borrowers will choose either option (i) or (ii).

Since most caps are purchased through an auction process, a bid package is usually assembled for the bidders, which includes the agreed-upon terms of the interest rate cap, the timeline for which the auction must be completed, the assignment of interest rate cap protection agreement, and the form of confirmation. The confirmation describes the particulars of the transaction, such as the loan amount, payment dates, accrual periods and other pertinent dates, the rates, and other material items necessary to understand the parameters of the interest rate cap. It is important to review the confirmation and the bid package to ensure all terms are correct, and accurately reflect the terms of the transaction. At closing, the borrower will collaterally assign the interest rate cap agreement, which is additional collateral for the loan, and ensures the lender's right to receive payments under the agreement.

While interest rate hedging takes many forms, interest rate caps are the most common derivative in mortgage financing. As we understand the process, we expect the market and traditional requirements to make implementation of this aspect of mortgage financing a smoother and simpler endeavor.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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When the interest rate on a mortgage financing is not fixed, the amount that a borrower may be required to pay may fluctuate depending on changes in the underlying index to which the “margin” or “spread” is tied. While a lender may be comfortable with its underwriting of a financing and the ability of its borrower to service its debt at closing, if the underlying index of a floating rate loan changes over time, the lender’s comfort and the ability of its borrower to service its debt will obviously change. To combat against interest rate volatility, borrowers and lenders usually agree to hedge the interest rate against the uncertainty in the market for floating rate loans. The most common form of such hedging is an “interest rate cap.”

An interest rate cap is a derivative whereby the interest rate cap provider (the “counterparty”) agrees to pay the interest which would be payable by the borrower over a strike price (the “strike”) on the notional amount (the principal amount) of the loan. Consequently, if the index of the loan rises above the strike, the counterparty, and not the borrower, is liable for the excess interest payment obligation. In this way, the borrower’s liability for payment of interest on the loan in question is always “capped” at an amount equal to the strike plus the spread.

As additional collateral for a loan, the borrower will purchase an interest rate cap and pledge it to the lender. Simply put, the interest rate cap is an insurance policy on a floating rate loan, which protects the borrower and the lender if the interest rate index rises above the strike during a specified period of time (the “term”). The term of the cap is usually coterminous with the initial term of the loan. If the loan is extended, extensions are usually conditioned on the purchase of a new interest rate cap for the extended period.

Caps are purchased upfront with a single payment at the closing of a loan. After the premium is paid, the borrower has no further payment obligations. Most lenders will require borrowers to purchase the interest rate cap as a condition to closing the loan. Lenders also require that the cap provider have a minimum credit rating from Moody’s, S&P, Fitch or another rating agency. The interest rate cap is usually auctioned to a number of creditworthy financial institutions to secure the most favorable terms at the lowest premium price. Lenders will require the counterparty to maintain a certain rating level during the term. In the event that the counterparty does not maintain its rating, the borrower will typically be required to (i) replace the counterparty with a new counterparty that meets the qualifications and execute a new interest rate protection agreement, (ii) require the counterparty to supply a guaranty from a party meeting the ratings default, or (iii) cause the counterparty to deliver collateral to secure its exposure to the borrower in an amount acceptable to the lender and the rating agencies. In most cases, borrowers will choose either option (i) or (ii).

Since most caps are purchased through an auction process, a bid package is usually assembled for the bidders, which includes the agreed-upon terms of the interest rate cap, the timeline for which the auction must be completed, the assignment of interest rate cap protection agreement, and the form of confirmation. The confirmation describes the particulars of the transaction, such as the loan amount, payment dates, accrual periods and other pertinent dates, the rates, and other material items necessary to understand the parameters of the interest rate cap. It is important to review the confirmation and the bid package to ensure all terms are correct, and accurately reflect the terms of the transaction. At closing, the borrower will collaterally assign the interest rate cap agreement, which is additional collateral for the loan, and ensures the lender’s right to receive payments under the agreement.

While interest rate hedging takes many forms, interest rate caps are the most common derivative in mortgage financing. As we understand the process, we expect the market and traditional requirements to make implementation of this aspect of mortgage financing a smoother and simpler endeavor.

Accounting for Interest Rate Caps

In March 2022, in an effort to fight inflation, the Federal Reserve raised its federal funds benchmark rate for the first time since 2018. Rate hikes have continued throughout the year rising from around 0% in the beginning of 2022 to almost 4% in November, a level which the U.S. has not seen in nearly 15 years. This means it is now more expensive to borrow money than it was a year ago, as borrowers will have to pay higher interest rates. Also, any borrower with preexisting debt that carries a variable interest rate based on underlying indexes will be affected by these rate hikes. However, interest rate caps are one way for companies to protect themselves from rising interest rates when holding variable rate debt.

An interest rate cap is an agreement that allows the borrower to negotiate a pre-determined cap on a variable interest rate. In other words, an interest rate cap is an insurance policy a borrower can take out against interest rate increases. These caps are purchased by the borrower, usually in conjunction with obtaining variable rate debt, and require a single upfront premium payment. The cost of this premium is dependent on a number of factors, but three key variables influencing the price are the notional, the term, and the strike rate. The notional is the amount of debt being hedged by the cap, typically a larger notional will cost more to cap the interest than a smaller one. The term is the length of time the cap will be effective, shorter terms will cost less than longer terms. The strike rate is the maximum interest rate the borrower will be responsible for paying and the rate at which the provider of the cap will start making payments to the borrower. While other external factors, like current market rate volatility, will also influence cap premiums, these factors play a crucial role in how much an interest rate cap will cost. But how do companies account for these interest rate cap contracts?

Accounting for interest rate caps  

When entering into an interest rate cap, the first step when determining the appropriate accounting treatment is to determine if the cap meets the criteria of a derivative. Under ASC 815, a derivative has all three of the following distinguishing characteristics:

• The settlement amount is determined by an underlying (the referenced rate) and a notional amount (the debt amount);
• The initial investment, the premium in the case of an interest rate cap, is either zero or smaller than the notional amount or the amount obtained by applying the notional amount to the underlying; and
• Net settlement is permitted or required, a market mechanism exists for net settlement (like market rates exceeding the strike rate), or the asset to be delivered is readily convertible to cash.

Based on the key terms associated with interest rate caps discussed previously, these will likely meet these three criteria of a derivative. Once that determination is made, the next step will be to determine if the interest rate cap qualifies for hedge accounting and if the company wants to elect hedge accounting. Derivatives are recorded at fair value on the balance sheet and without hedge accounting, changes in fair value of the cap would be recorded through earnings in each reporting period. However, the implementation of hedge accounting is optional and is an election a company can make.

Hedge accounting involves the designation of a derivative as a hedging instrument and designating the hedge item, either a recognized asset or liability that is not remeasured at fair value, an unrecognized firm commitment, or a forecasted transaction (variable interest on debt). ASC 815-20-25 discusses the often-complex criteria that must be met for transactions to qualify for hedge accounting, which include the following:               

• Formal designation and documentation at hedge inception.
• Eligibility of hedged items and transactions.
• Eligibility of hedging instruments.
• Hedge effectiveness.

While a company will have to perform a complex analysis to determine if its derivatives meet each of the criteria to qualify for hedge accounting, in many cases, interest rate caps will qualify for hedge accounting as they hedge the increase of interest payments, a forecasted transaction, protecting the borrower from exposure to increased interest rates.

As mentioned above, ASC 815 requires all derivatives to be recognized at fair value on the balance sheet. However, the accounting for changes in the fair value of a derivative that qualifies for hedge accounting will depend on the type of hedge it is. Some of the common types of hedges include cash flow hedges, fair value hedges, foreign currency hedges, and net investment hedges. An interest rate cap would fall under the definition of a cash flow hedge, which is a hedge of the exposure to variability in the cash flows of a forecasted transaction. As such, the recognition of changes in the fair value of an interest rate cap are recorded in other comprehensive income (OCI) until the hedged transaction impacts earnings, which in this case is when the strike rate is exceeded and the provider of the cap starts making payments to the borrower, at which time a portion of the amounts reported in OCI will be reclassified to earnings.

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• National Rates and Rate Caps
• National Rates and Rate Caps - Previous Rates

Monthly Update

On December 15, 2020, the FDIC Board of Directors approved a Final Rule - PDF making certain revisions to the interest rate restrictions applicable to less than well capitalized institutions (as defined in Section 38 of the Federal Deposit Insurance Act), which are effective on April 1, 2021. The interest rate restrictions generally limit a less than well capitalized institution from soliciting deposits by offering rates that significantly exceed rates in its prevailing market.

The Final Rule redefined the “national rate” as the average of rates paid by all insured depository institutions and credit unions for which data is available, with rates weighted by each institution’s share of domestic deposits. The “national rate cap” is calculated as the higher of: (1) the national rate plus 75 basis points; or (2) 120 percent of the current yield on similar maturity U.S. Department of the Treasury (U.S. Treasury) obligations plus 75 basis points. The national rate cap for non-maturity deposits is the higher of the national rate plus 75 basis points or the federal funds rate plus 75 basis points.

A less than well capitalized institution may use the “local rate cap” in place of the national rate cap for deposits gathered from within the institution’s local market area. The Final Rule redefined the “local rate cap” for a particular deposit product as 90 percent of the highest rate offered on the deposit product by an institution or credit union accepting deposits at a physical location within the institution’s local market area.

In accordance with Section 337.7(d), an insured depository institution that seeks to pay a rate of interest up to its local market rate cap shall provide notice and evidence of the highest rate paid on a particular deposit product in the institution’s local market areas to the appropriate FDIC regional director. The institution shall update its evidence and calculations for existing and new accounts monthly unless otherwise instructed by the appropriate FDIC regional director, and retain such information available for at least the two most recent examination cycles and, upon the FDIC’s request, provide the documentation to the appropriate FDIC regional office and to examination staff during any subsequent examinations.

Monthly Rate Cap Information as of August 19, 2024

The FDIC began posting the National Rate and Rate Cap on May 18, 2009. Data is not available prior to May 18, 2009. Data from May 2009 through March 31, 2021, reflects the calculation in effect at that time (averages weighted by branch, and not including credit unions), while data posted after March 31, 2021, reflects the calculation described above.

This historical data can be accessed at Previous Rates .

The monthly rate cap information will be published every 3rd Monday of each month. When the 3rd Monday falls on a Federal holiday, the rate cap information will be published on the next business day. All published rates and yields are based on information available on the last business day of the prior month end (note: rates and yields published on April 1, 2021, are based on information available as of February 26, 2021).

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If an institution seeks to offer a product with an off-tenor maturity that is not offered by another institution within its local market area, or for which the FDIC does not publish the national rate cap, the institution will be required to use the rate offered on the next lower on-tenor maturity for that deposit product when determining its applicable national or local rate cap, respectively. For example, an institution seeking to offer a 26-month certificate of deposit must use the rate offered for a 24-month CD to determine the applicable national or local rate cap.

Source: S&P Capital IQ Pro; SNL Financial Data. Calculations: FDIC. Savings and interest checking account rates are based on the $2,500 product tier, while money market and certificate of deposit rates represent an average of the $10,000 and $100,000 product tiers. Account types and maturities published in these tables are those most commonly offered by the banks and branches for which we have data (on-tenor maturities).

As noted above, in determining the National Rate Cap for a particular on-tenor maturity, the Final Rule requires the FDIC to calculate 120 percent of the current yield on similar maturity U.S. Treasury obligations plus 75 basis points. For on-tenor maturities for which the U.S. Treasury publishes a yield, the treasury yields (treasury.gov) in this column are those that are published by the U.S. Treasury for the corresponding obligation with the same maturity. For on-tenor maturities for which the U.S. Treasury does not publish a yield, the treasury yields in this column are the published Treasury yields for the obligation with next lowest maturity, which is viewed as a similar rate, as provided for in the Final Rule. For non-maturity deposits, where there is no comparable treasury yield, the yield used is the effective federal funds (newyorkfed.org) rate published by the Federal Reserve Bank of New York.

The Final Rule defines a maturity of 48 months as an on-tenor maturity. Since the U.S. Treasury does not publish a rate for a 48-month Treasury obligation the applicable Treasury Yield is the 36-month Treasury; see footnote 3.

Last Updated: August 19, 2024