When a commercial property has a floating interest rate loan, it may come with a “cap” (or maximum limit) on the highest allowable interest rate during the term of the loan. It also may or may not come with a “floor” limiting the lowest allowable interest rate.
An interest rate cap helps minimize the risk for borrowers on a floating rate commercial property loan. Borrowers usually select floating-rate property loans with variable interest rates during periods when interest rates are very low; if the rates get even lower, the borrower benefits. But the borrower may end up with vastly increased financial risk if interest rates rise rapidly or significantly during the loan term.
For example, a borrower can get a 10-year commercial property loan which charges 4% interest with an interest rate cap of 7%. The interest rate can go up or down but will not go above 7%.
Capping the rate decreases the risk of default. The interest rate cap may apply during a specific period of the loan – such as the first 1-3 years – or for its entire lifetime. An interest rate“floor” works the opposite way, ensuring that the loan can meet the lender’s return expectations even if rates go down significantly.