What Is an Interest Rate Collar?
An interest rate collar is a financial management tool meant to insulate borrowers with adjustable-rate loans from severe rises in prevailing interest rates. Through the use of various financial hedges, an interest rate collar places a "cap" on the rate of interest that can be charged to the loan, as well as a "floor" on the interest rates paid for loan.
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The Cap
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Interest rate collars are created through the use of financial derivatives. To establish the cap, the borrower will pay a fee to an investor who agrees to pay the interest on a loan past a certain rate. For example, an investor may agree to take on the portion of interest payments above 7 percent. In this sense, the cap is like an insurance policy for the lender to prevent them from paying too much in interest.
The Floor
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To offset the cost of paying for the cap on the interest rates, the borrower will sell a "floor" to investors. In this case, investors are essentially betting that interest rates will extend below a certain point. If interest rates do drop below the floor rate, the borrower will pay the investor the difference between the floor price and the actual price of interest. For example, if the floor is set at 2 percent, but the interest rates drop to 1.5 percent, the investor who bought the floor will pocket interest payments of 0.5 percent.
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Function
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Interest rate collars function as a kind of insurance policy for borrowers that protects them from paying large interest rates. However, by selling a floor in conjunction with buying the cap, the interest rate collar can pay for itself. The downside is that the borrower gives up the savings that would be provided to him if the interest rate were to dip to a very low level.
Types
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Interest rate collars can be set at a number of different levels, depending on the borrower's needs. While in some cases the cost of the cap will exactly offset the cost of the floor, in other cases the two derivatives may not match up. To gain a small profit, the floor may be sold for more -- generally meaning the borrower will agree to a higher rate -- or the borrower may be willing to pay more for a lower cap.
Considerations
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According to the investment firm CIT Capital Securities, clients who choose to purchase an interest rate collar should remember that the ceilings and floors apply only to the interest rate, but do not affect any fees or margins applied by the lender. So, if a lender charges a 2 percent margin on a loan and the collar sets a ceiling of 10 percent on the underlying rate of interest, the borrower may end up paying as much as 12 percent interest.
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