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Interest rate caps can save you money on your loan. - Interest rate caps are available on a number of different types of loans, both commercial loans and personal loans. They are only used on loans that have adjustable interest rates that fluctuate with the market. Interest rate caps can either set a maximum interest rate that you will pay, such as 7 percent, or limit the amount the rate can change, such as no more than 3 percent. Mortgages can have two types of interest rate caps. A periodic cap limits the amount the interest rate can change each time the rate is reset and a lifetime cap limits the amount the rate can change over the term of the loan.
- Having an interest rate cap on your loan allows you to limit your risk of the interest rate skyrocketing and having to pay a significantly larger percentage while still leaving you the opportunity to take advantage of lower rates should interest rates fall. For example, if you took out a adjustable rate loan at 7 percent with an interest rate cap of 9 percent, if interest rates fell to 5 percent, you would only pay 5 percent interest. However, if interest rates jumped to 11 percent, you would only pay 9 percent interest.
- The interest rate that you will pay on your loan will fluctuate with the market rate that it is tied to. The most common indexes are the yield on a one-year Treasury bill, the 11th District Cost of Funds index and the London Interbank Offered Rate. The lender will add a percentage to the market rate to account for the potential for you to default on the loan, which will vary based on your credit worthiness, and a percentage for the lender's profit.
- In addition to protecting yourself against a jump in interest rates, some lenders like Wachovia will allow you to sell the interest rate cap back for a price if you pay off the loan early. Also, the cost of the interest rate cap is low and lenders will often allow you to roll the cost into the interest rate cap into the loan.
- You can purchase an interest rate cap from a different financial institution than the one that issues you your loan. For example, you may have a loan issued by Bank of America but an interest rate cap that you purchased from Wachovia. You may choose to do this because a different bank offers a lower price for the interest rate cap. When this happens, you will make regular payments to the bank that you took out the loan from but you will be reimbursed for interest charges exceeding the rate cap by the bank that you have the interest rate cap from.
