An interest rate cap sets an upper limit, or ceiling, that the interest rate charged on a loan or credit facility can adjust to.
Such features of a credit facility are understandably only found in loan contracts where the interest rate can rise or fall based on various factors such as the performance of indices.
The implication of this is that interest rate caps would not be inserted as terms of loans such as personal loans and car loans as the interest rate on such products are set at the time of borrowing.
The most common product that interest rate caps are found in are home loans as they have floating interest rate that are mostly determined by a variable component that is dependent on index rates.
Home loan interest rate cap
All Singapore home loans offered by the bank are either floating rate loans, or would eventually become floating rate loans.
This is because even fixed rate mortgages would only enable a borrower to enjoy fixed rate for a short period of time, and latter convert to an adjustable rate mortgage.
The floating interest rate is based on an index rate (or base rate) plus a spread.
For example if the index rate is based on 3mSIBOR which is currently at 1.5% and the spread set by the lender is 1%, the the total interest rate charged on the housing loan would be 2.5%.
Should 3mSIBOR rise to 2% at the next refresh period, then the new interest rate would be 3%.
This sudden rise in interest rate can be scary to borrowers. Especially those who have maxed out their household budget to service the mortgage.
But if there is an interest rate cap of 2.75% on the mortgage, then the interest rate that the borrower would pay would be 2.75% regardless of how high SIBOR rises.
Even if SIBOR rises to 5%, the interest which the borrower would pay would still be limited to 2.75%.
This is how interest rate caps protect home loan borrowers from rising interest rates.
In a way, floating rate loans are like fixed rate loans… but better.
This is because they tend to fluctuate below the interest rate limit, and would not rise above it. This effectively means that a borrower would be charged at a fixed rate or less.
Lender risks
On the opposite side of the equation, the longer a lender charges a mortgage rate at the ceiling rate rather than a higher rate based on the market, the more money the lender would lose.
This is because indices are reflections of the costs of credit to lenders.
If a lender has to borrow funds at 5% but only lend it to a home owner at 2.75%, they would be booking a loss with every installment made.
So to protect themselves from being chained to an interest rate cap throughout the entire life of a loan, the interest rate limits are usually only active for the first few initial years of the term loan.
It wouldn’t make financial sense from the lender’s perspective to offer interest rate caps indefinitely.
