What does it mean to cap a loan?
Investopedia explains it best:
“If the variable rate on a similar loan goes above the capped rate, the capped rate loan holder gets the benefit of not having to pay the extra portion. While this is a benefit, capped rate loans may have higher interest rates than a traditional fixed rate loan.”
A normal interest rate is allowed to fluctuate, taking into account market forces and the rate of inflation amongst other things. This means that although you may agree on a base amount when borrowing money, the rate can change quite drastically depending on market stability.
Setting a cap on an interest rate is a means of escaping market fluctuations and a potential hike in your interest rate. For example, you could take out a 10-year loan at a rate of 6% with a capped rate of 9%. This means the interest rate can fluctuate up and down, but it can never go higher than the 9% cap.
Capping your rate will provide you with a hybrid of a fixed and variable rate loan. The fixed part comes from the capped rate itself, and the variable part comes from the loan’s ability to move up or down with market fluctuations. It is currently a good time to cap as we are reaching the bottom of interest rate cycling, that is to say rates will soon be rising again and capping may be able to protect you from potential increase in your payments.
There are 2 main ways of capping in France; you can cap the rate or cap the repayment.
- Capping the Rate: You could take a fixed rate though you will be liable to penalties for early redemption. Instead if you cap the rate then you know from day one what your maximum rate will be and will avoid penalties for paying off the loan early (except if you re-mortgage).
- Capped repayment: with this product the rate is variable but the monthly repayment is ‘locked’ and can only go up by rate set by INSEE (The National Institute of Statistics and Economic Studies). If the base interest rate increases then the bank can increase the term of the loan by up to 5 years. Once the 5 year extension has been reached, the monthly payment will start to edge up but only by the inflationary rate, not by the interest rate increase.
The main advantage of capping is that the starting rates are currently very low so you will be securing your repayments at a good rate. As you can repay without penalty, you can also control the terms by saving separately and making ad hoc payments if you choose to.