What you should know about interest rate caps

What you should know about interest rate caps

Islay Robinson

With the “will-they-won’t-they” question of interest rate rises many of our clients have been asking about the best way in which to mitigate risk on their mortgage borrowing.

A popularised solution promoted by the press is to “fix” your mortgage which is often advantageous if you manage to get a good rate. However, the gamble of leaving your fantastic variable tracker for a looming base rate rise which might not happen for quite some time is a hard bet to hedge.

Yet, the decision doesn’t have to necessarily be black and white. Enness explore options within the grey area and because of our access to banks we are always privy to new and innovative offerings.

One such offering is an interest rate cap. These were a popular solution before the financial crisis and now look to be making a resurgence. One particular private bank we work with are offering this stand-alone solution as a purchasable instrument you can use to protect yourself against the risk of an interest rate rise.

This product is suitable for you if you have a variable rate mortgage – whether you are a buy to let landlord with a property portfolio or a private individual wishing to protect your residential property.

An interest rate cap allows you to mitigate your interest rate risk by paying a one-off, upfront premium in order to hedge against the risk of rising interest rates. This particular solution is a standalone hedge that can be referenced to any existing or new loan. The cap operates on a pre-agreed amount of debt, period of time, repayment profile, underlying interest rate and repayment frequency.

What are the benefits of investing in an interest rate cap for your mortgage?

  • The investor is compensated for interest rate increases above the cap level
  • The investor can benefit from a low interest rate environment, as opposed to being locked into a fixed rate.
  • It is possible to sell the cap back in the secondary market and recoup some of the initial premium that was paid.
  • In the case of strong interest rate rises, the potential profit is high compared to the premium paid.

What are the risks of investing in an interest rate cap for your mortgage?

  • Just like many insurances, you must pay an upfront premium which is not returned during the life of the cap or at maturity. However…..

What are the key features of an interest rate cap?

  • The cap level applied to the underlying interest rate is initially determined by you. A payment is triggered if the interest rate hedged is higher than the cap level
  • It is not fixed to a particular loan. A cap can therefore be used to hedge a loan that has been issued by a different bank

If this sounds like a product of interest to you then we are more than happy to make an introduction on your behalf to this exclusive private bank.