The price of this protection depends on the predicted level of interest rates over the 5 year period. As such the cost of this protection is low when the expectation is that rates will be low for a period of time. As soon as the prospect of increasing rates is back on the agenda then the price of this protection will increase significantly. It is the expectation of interest rate rises that sets the price. Once rates actually start to move it may not be viable to purchase protection due to the increased cost.
An interest rate cap is basically an insurance against rises in the interest rates. Caps can be arranged to protect against rises in the Base/LIBOR rate over 3, 3.5 or 4% for a term of 3-5 years*. The Cap is purchased using a one off up front premium. Once in place the cap will pay out if the Base/LIBOR rate exceeds the chosen level.
A client has a £1m loan. The client’s mortgage tracks the Base Rate with a 1% margin and 5 years remaining. The rate applicable to the loan is Base Rate plus a margin of 1% for a 10 year term with 5 years remaining. With the Base Rate at 0.5% this client is currently paying 1.5% per annum for the £1m loan. The client is concerned that Base Rates could move up quickly in the next five years and therefore buys an Interest Rate Cap at 3%. The Cap is purchased with a one off premium and is owned by the client. This is held as an asset that can be sold at any time. The value of this asset will fluctuate and could be worth less than they paid for it.
During the 5 year term of the product the Interest Rate Cap will pay out at any time that the Base Rate is above 3%, therefore effectively capping the rate at this level. The customer will continue to pay the mortgage at the original rate of Base Rate plus 1% lending margin but will receive from the Cap a payment equal to the difference between 3% and the prevailing level of the Base Rate. Whenever the Cap is being used the payments are arranged for the same day as the mortgage payment is taken in order to net off for cash flow purposes.
| Year | Base Rate (per annum) |
Payment Received from Cap (per annum) |
|---|---|---|
| 1 | 3% | 0% |
| 2 | 4% | 1% |
| 3 | 6% | 3% |
| 4 | 7% | 4% |
| 5 | 7% | 4% |
If the Base Rate does not rise above 3% over the 5 year term then the premium will have been paid but the Cap will have not been used at any point.
All clients must open a current/savings account with the bank. In order to do this they must fulfil one of the following criteria;
Minimum notional loan size £500,000 -
*other rates and term lengths can also be arranged
Please note that any money paid out as a result of the Base/LIBOR rate exceeding the chosen cap level may be considered as taxable income for the purposes of United Kingdom taxation.
Certain types of investor may be able to obtain tax deductions or use losses to offset this taxable income.
Tax treatment depends on individual circumstances and may be subject to change in future. This does not constitute tax advice. Accordingly, you should consult a professional adviser in relation to your tax position.