An interest rate cap is an over-the-counter derivative that protects a floating-rate borrower against the benchmark rate rising above a predetermined strike rate for a specified term. When SOFR exceeds the strike, the cap provider pays the borrower the difference on the notional amount. The buyer pays a one-time premium upfront and owes nothing further.
How does an interest rate cap work?
The buyer, typically a floating-rate borrower, chooses a strike rate, a notional amount, and a term. For as long as the cap runs, any period in which SOFR settles above the strike produces a payment from the cap provider equal to the excess rate applied to the notional. If SOFR stays at or below the strike, the cap pays nothing and the borrower simply pays the loan’s floating rate.
Cap payment for a period = (SOFR minus strike rate, when positive) x notional x the fraction of the year in the period
Illustrative example (round numbers):
| Input | Value |
|---|---|
| Notional amount | $20,000,000 |
| Strike rate | 4.00% |
| SOFR for the period | 5.00% |
| Rate above the strike | 1.00% |
| Annualized payment from the cap provider | $200,000 |
| Monthly payment (one twelfth of the year) | about $16,700 |
| Payment if SOFR were 3.50% instead | $0 |
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 is a cap priced?
Cap pricing depends on four variables: the strike rate, the notional amount, the term, and implied volatility in interest rate markets. A lower strike (more protection) costs more, a longer term costs more, and higher volatility costs more.
In a high-rate, high-volatility environment, cap premiums are substantial. A two-year cap on a $30 million loan might cost $500,000 or more depending on the strike. That is real money that affects deal economics and must be budgeted at origination. Quoting the strike in basis points above current SOFR is the usual way to compare the cost of different protection levels.
What happens when a cap expires before the loan matures?
The most common operational issue with caps is expiration timing. If a bridge loan has extension options, the original cap may expire before the extended maturity date, and the lender then requires a replacement cap at then-current market pricing. Borrowers are routinely surprised by the cost of replacement caps in rising rate environments.
The cap also carries a residual value while it runs. Its mark-to-market reflects current rates, volatility, and the time left to expiration, which matters when a refinancing or sale happens before the cap ends.
How interest rate caps show up in LoanBoss
LoanBoss tracks hedge requirements with live mark-to-market values and replacement cap costs, and lists replacement caps among the critical dates it monitors. Cap expiration dates, replacement requirements, strike rates, and residual cap value are tracked across the floating-rate portfolio, and Pensford provides institutional-grade cap pricing and execution.
Frequently Asked Questions
What does a cap provider pay when SOFR rises above the strike?
The difference between SOFR and the strike rate, applied to the notional amount for that period. With a 4.00% strike and SOFR at 5.00%, the provider pays the 1.00% difference on the notional. If SOFR is at or below the strike, nothing is paid.
Does a cap require ongoing payments?
No. A cap is purchased upfront for a one-time premium, and the buyer makes no further payments for the life of the contract. Payments only flow one way, from the cap provider to the borrower.
Why do lenders require interest rate caps?
Most bridge lenders and floating-rate agency lenders require a cap as a condition of the loan because it limits the borrower’s interest expense, and therefore protects debt service coverage, if the benchmark rate rises.
What determines the cost of a cap?
Four variables: the strike rate, the notional amount, the term, and implied volatility in interest rate markets. Lower strikes, longer terms, and higher volatility each increase the premium.
What is a replacement cap?
A new cap purchased when the original expires before the loan does, for example when a bridge loan is extended past the cap’s term. It is priced at then-current market levels, which in rising rate environments is often far more than the original premium.
Related Terms
- Floating Rate
- SOFR
- Basis Point
- Hedge Mark-to-Market
- Fannie Mae DUS
- Caps in Your Debt Portfolio: What to Track and When to Act
- Hedge Requirements in Loan Documents: Replacement Caps, Swap Mark-to-Market and What Lenders Test
- Interest Rate Cap Cost: What Drives the Premium
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.
Sources
- LoanBoss CRE Debt Glossary