An interest rate cap is an over-the-counter derivative contract that provides the buyer (typically a floating-rate borrower) with protection against the benchmark interest rate exceeding a predetermined level — called the “strike rate” — for a specified term. If SOFR rises above the strike rate, the cap provider pays the borrower the difference, effectively capping the borrower’s interest expense. For example, if you buy a cap with a 4.00% SOFR strike and SOFR rises to 5.00%, the cap provider pays you the 1.00% difference on your notional amount. Caps are purchased upfront for a one-time premium and require no ongoing payments from the buyer. Most bridge lenders and floating-rate agency lenders require borrowers to purchase caps as a condition of the loan.
How It Works in Practice
Cap pricing depends on four variables: the strike rate, the notional amount, the term, and implied volatility in interest rate markets. Lower strike rates (more protection) cost more; longer terms cost more; higher volatility costs more. In a high-rate, high-volatility environment, cap premiums can be substantial — a two-year cap on a $30 million loan might cost $500,000 or more depending on the strike. This is real money that affects your deal economics and must be budgeted at origination. The most common operational issue with caps is expiration timing: if your bridge loan has extension options, your original cap may expire before the extended maturity date, requiring a replacement cap at then-current market pricing. Borrowers are routinely surprised by the cost of replacement caps in rising rate environments. LoanBoss tracks cap expiration dates, replacement requirements, strike rates, and residual cap value across your floating-rate portfolio, and Pensford provides institutional-grade cap pricing and execution.
Related Terms
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.