Interest Rate Ceiling

Interest Rate Ceiling

An interest rate ceiling is the maximum interest rate permitted in a particular transaction. In addition to specifying a maximum interest rate level, variable rate loans can also include conditions for how quickly interest rates can rise up to that maximum level. To protect against this, ARM contracts often include interest rate ceilings which ensure that the interest rate used in the loan cannot rise beyond a certain level during the mortgage term. An interest rate ceiling is a contractual provision outlining the maximum interest rate permitted for that transaction. In recent times, however, interest rate ceilings are often used to protect against interest rate risk.

An interest rate ceiling is a contractual provision outlining the maximum interest rate permitted for that transaction.

What Is an Interest Rate Ceiling?

An interest rate ceiling is the maximum interest rate permitted in a particular transaction. It is the opposite of an interest rate floor.

Financial transactions often include an interest rate ceiling as part of their contractual provisions. For example, they are commonly used in adjustable-rate mortgage agreements (ARMs).

An interest rate ceiling is a contractual provision outlining the maximum interest rate permitted for that transaction.
They are commonly used in variable-rate loans, such as ARMs.
Together with similar measures such as capped increase provisions, interest rate ceilings are designed to protect borrowers against interest risk. However, they can also benefit lenders by reducing the risk that borrowers will default on their loans.

Understanding Interest Rate Ceilings

An interest rate ceiling, also known as an interest rate "cap," is the maximum interest rate that a lender can charge a borrower when negotiating a loan. Interest rate ceilings have been a part of commerce for thousands of years, where they have traditionally served to protect borrowers against predatory lending practices.

In recent times, however, interest rate ceilings are often used to protect against interest rate risk. That is, to protect borrowers against the risk that interest rates might rise significantly during the life of a particular contract.

Usury laws have ancient origins and have existed in every major religious tradition; U.S. usury statutes were based on the English model and are designed to curtail abusive lending practices.

In addition to specifying a maximum interest rate level, variable rate loans can also include conditions for how quickly interest rates can rise up to that maximum level. Often, these so-called "capped increase" provisions will be set at roughly the rate of inflation, which hovers around 2% today.

Generally speaking, interest rate ceilings and capped increase provisions are particularly beneficial to borrowers when interest rates are rising overall. After all, if a max interest rate is reached before a loan reaches its maturity, it is possible that the borrower will be able to pay below-market rates of interest for a long period of time. This creates an opportunity cost for the bank because, if not for the interest rate ceiling, they could lend their money to a new borrower at the newer and higher rate of interest.

In the United States, as well as in several other countries throughout the world, various laws and regulations exist relating to interest rate ceilings. One common example is usury laws, which outline the maximum interest rates that are permissible under law. Typically, these rates hover around 35%, although exceptions do exist for some lenders, such as those specializing in payday loans.

Real-World Example of an Interest Rate Ceiling

To illustrate, consider the case of an ARM. A borrower may be quite capable of servicing an ARM at the interest rates prevalent at the time that mortgage was negotiated. However, if interest rates continue to rise indefinitely throughout the duration of the mortgage, most borrowers will eventually become unable to service the loan. To protect against this, ARM contracts often include interest rate ceilings which ensure that the interest rate used in the loan cannot rise beyond a certain level during the mortgage term. 

In many ways, this provision is a benefit to both parties: in addition to reducing the borrower's interest rate risk, it also reduces the risk that the borrower will default on their loan, thereby reducing the lender's risk.

Related terms:

Annual ARM Cap

An annual ARM cap limits the possible increase in an adjustable-rate mortgage's (ARM) interest rate during each year. read more

Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage is a type of mortgage in which the interest rate paid on the outstanding balance varies according to a specific benchmark. read more

Default

A default happens when a borrower fails to repay a portion or all of a debt, including interest or principal. read more

Inflation

Inflation is a decrease in the purchasing power of money, reflected in a general increase in the prices of goods and services in an economy. read more

Interest Shortfall

An interest shortfall is the amount of monthly interest that remains due after the borrower has made their payment, leading to negative amortization. read more

Interest Rate , Formula, & Calculation

The interest rate is the amount lenders charge borrowers and is a percentage of the principal. It is also the amount earned from deposit accounts. read more

Interest Rate Collar

An interest rate collar is an options strategy that limits one's interest rate risk exposure. read more

Interest Rate Floor

An interest rate floor is an agreed upon rate in the lower range of rates associated with a floating rate loan product. read more

Interest Rate Risk

Interest rate risk is the danger that the value of a bond or other fixed-income investment will suffer as the result of a change in interest rates. read more

Lifetime Cap

The lifetime cap is the maximum interest rate that is allowed to be charged on an adjustable-rate mortgage. read more