What Is Interest Rate Capping? (And How It Can Help Your Business)

Sep 20, 2023 | Small Business

It is no secret that interest rates are rising. Just look at the total on any receipt you’ve gotten recently. The cost of everything has gone up, especially the cost of borrowing money.

If you want to take out a loan to expand your business (or just keep the doors open during a difficult season), you may want to talk to your lender about a rate cap on the interest.

“What is interest rate capping?”, you ask. We’ll unpack it in this post and equip you to make even more informed decisions to help grow your business.

what is a rate cap

What Is Interest Rate Capping Used For?

Interest rate capping is a tool used in the financial world to help borrowers when they are looking for a loan in a rising interest rate environment. It’s a way of building some peace of mind into your lending agreement so you can sleep a little better at night knowing your rate can only go so high.

Interest rate capping is common in all kinds of situations where a variable interest rate is used. It shows up most often in residential real estate deals structured around an Adjustable Rate Mortgage (ARM) or commercial real estate mortgages.

What Is A Rate Cap?

A rate cap establishes a maximum interest rate that a borrower can be charged for a particular loan. It lets them know on the front end of a variable rate product what their “worst case scenario” will be, financially speaking.

It allows both the lender and the borrower to build in a “hedge” against rising or fluctuating interest rates in an unstable market environment.

How Do Interest Rate Caps Work?

Rate caps can be structured in many different ways, and lenders have a lot of flexibility in this area.

For instance, the lender could set a limit on how high the interest rate on the loan could possibly go. The rate is adjustable and the borrower understands that it will increase at some point, but capping it lets them know that it will never go beyond a certain point, no matter how much interest rates rise in the general market. 

They could also set a limit on how many times the rate is able to be increased during the life of the loan. Twice? Three times? Four? There are no set rules regarding how often the rate can be adjusted, but having that number locked in at the beginning of the loan also keeps the borrower from being caught by surprise down the road.

Here’s how it might play out in a real estate deal:

  • When a loan requires a cap to be set, the borrower will go to an interest rate cap provider, a third-party financial institution referred to in the deal as the “counterparty.”
  • The counterparty agrees to pay the interest that would have otherwise been payable by the borrower if the interest rate goes above a predetermined point, known as a “strike price” or “strike rate.” 
  • “Strike rate” is usually determined by the Secured Overnight Financing Rate (SOFR)
  • The current SOFR is 5.3%. 
  • Let’s say the interest rate cap purchased is 2%, but the SOFR jumps from 5.3% to 8%. 
  • Because of the cap, the borrower will never pay more than 7.3% (5.3 + 2) in interest.
  • If the index rate of the loan rises above the capped rate during a set period of time (usually the same as the term of the loan), the counterparty agrees to pay the difference to the lender.

We get it. That can sound pretty complicated. But it’s an effective way to help everyone involved in adjustable rate deals to be comfortable that they aren’t going to be left high and dry if something goes wrong.

Often, without any sort of interest rate capping “insurance”, as adjustable rates rise the borrowers find themselves having a hard time making monthly payments on the loan. (Since, as the rates go up, so does the amount of each payment.) Lenders know this, and that makes them hesitant to get into those kinds of loan situations. 

But by including an outside “counterparty” who is willing to underwrite the difference in case rates go up beyond a set point, lenders’ comfort levels rise and borrowers can get their much-needed loans.

how do interest rate caps work

We Can Help You Get The Financing You Need

One of the services we provide our small business clients is assistance with bank financing. It’s part of several things we offer through our CFO Consulting Services.

When you attempt to take out a loan, but show up unprepared it sends a message to the lender that you might be a risky customer to partner with. We believe you deserve to be able to put your best foot forward when you’re working hard to grow your business.

So when you team up with our financial experts (who have over 40 years of experience working with owners just like yourself, by the way), you’ll confidently walk into any bank with a loan proposal that includes:

  • An Executive Summary – clearly explaining what the loan is needed for, the exact amounts required, and why it benefits the lender to partner with you
  • Pro-forma Cash Budgets and Financial Statements – demonstrating to the bank that you are in a stable position to be able to honor the terms of the loan you’re looking for
  • Owners’ Personal Financial Statements – showing, if necessary, that you have sufficient collateral to offer as security for the loan
  • Representation – (probably the most important element) representing you and your financial position to the lender in person on your behalf

So it’s ok if you don’t fully understand interest rate capping or other things associated with securing loans for your small business. We do.

It’s what we’ve done for decades, and we’d love to show you what our team can do for you. Schedule a call today to learn more!

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