| Detail | Explanation |
|---|---|
| What it limits | The index on a floating-rate loan, not the spread |
| Paid by | The borrower, as an upfront premium at purchase |
| Key terms | Strike rate, notional amount, and term |
| Common on | Bridge, construction, and floating-rate agency and CMBS loans |
| Usually pledged to | The lender, as additional collateral |
How does an interest rate cap work?
A cap is a separate contract between the borrower and a cap provider, typically a bank with an acceptable credit rating. The borrower pays a single premium upfront. For each interest period, the index is compared to the strike. If the index is above the strike, the provider pays the borrower the excess on the notional amount for that period. If it is at or below the strike, nothing is owed and the borrower has no further cost.
The cap limits the index only. The loan's spread stays in place, so the highest rate a borrower pays is the strike plus the spread. Payments under the cap are usually assigned to the lender and applied straight to debt service.
Cap payment for a period = max(0, index minus strike) x notional x (days in period / day count basis)
Why do lenders require a cap?
A floating-rate loan is sized on today's index. If SOFR rises sharply, interest cost can exceed the property's net operating income during a renovation or lease-up. The cap sets a ceiling on that exposure, which protects the lender's debt service coverage assumptions and the interest reserve.
The loan agreement typically specifies the strike, the minimum term, the notional amount (often the full loan commitment), the provider's minimum rating, and whether the borrower must buy a replacement cap when a loan is extended. The extension requirement often matters more than the original purchase, because a replacement cap is priced on the rate outlook at the extension date.
What drives the cost of a cap?
Because the premium is paid upfront, it belongs in the sources and uses at closing. Sponsors often compare a higher strike with a cheaper premium against a lower strike with more protection, and check both against the lender's minimum strike. Run the DSCR calculator at the strike plus the spread to see coverage in the worst case the cap allows. If the lender's cap terms change how much the loan can carry, submit the deal and Capital Partners will compare structures.
- Strike distance: a strike close to the current index costs more than a strike far above it
- Term: a longer cap covers more periods and costs more
- Notional: premium scales with the amount hedged
- Expected rate volatility: higher market volatility raises the premium
- Forward rate curve: if markets expect rates to rise, caps cost more
Worked example
In this hypothetical example, a $30,000,000 bridge loan carries a 3.00% spread over SOFR, and the borrower holds a cap with a 5.00% strike on the full balance. Assume SOFR rises to 6.00% for a full year. All figures are illustrative.
| Item | Rate | Annual amount |
|---|---|---|
| Loan interest at SOFR plus spread | 9.00% | $2,700,000 |
| Cap payment (index above strike) | 1.00% | $300,000 |
| Net interest cost to borrower | 8.00% | $2,400,000 |
Common questions
Is an interest rate cap the same as a swap?
No. A swap converts a floating rate to a fixed rate, and the borrower pays if rates fall below the fixed rate. A cap only pays out when rates rise above the strike, and the borrower keeps the benefit if rates fall. The trade-off is the upfront premium.
Who owns the interest rate cap?
The borrower buys and owns the cap, but it is almost always collaterally assigned to the lender. Payments from the provider go to the lender or into a lender-controlled account and are applied to interest.
Do I need a new cap when I extend my bridge loan?
Usually yes. Most floating-rate loan agreements make an extension conditional on buying a replacement cap for the extension term at a strike the lender sets. Budget for that cost when you model the extension.
Can I sell an interest rate cap?
A cap has market value while it is in force, especially when rates are near or above the strike. It can sometimes be sold or terminated when a loan is paid off, subject to the lender's release of its assignment.
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