An interest rate cap is a contract the borrower buys that pays the lender's servicer whenever the loan's floating index rises above a set strike rate. Lenders on floating-rate loans require one so that debt service has a ceiling, and the cap's strike, term, notional amount and provider are all written into the loan documents. Later costs also matter: the monthly reserve for a replacement cap, which is re-priced as rates and volatility move, and the obligation to buy a new cap at expiration whatever it costs.
This guide uses Fannie Mae's published rules as the reference point because they are published in detail. Bridge, bank and debt fund lenders write their own cap requirements, so treat the agency rules as a benchmark and read your term sheet for the specifics.
How a cap works on a floating-rate loan
A floating-rate loan charges an index plus a fixed margin. Fannie Mae's Structured ARM (SARM), for example, uses the 30-day Average SOFR as its index. Freddie Mac's Guide describes the same structure: the rate for each period equals the index rate plus the margin, and "the margin will remain fixed during the term of the Mortgage."
The cap is a separate contract from the loan. Four terms define it:
- Strike rate. The index level above which the provider pays. If the index is 4.60% and the strike is 4.00%, the cap pays 0.60% on the notional for that period.
- Notional amount. The balance the payment is calculated on. Fannie Mae's FAQ says the notional "must equal or exceed the Unpaid Principal Balance of the Mortgage Loan at the time the cap is purchased."
- Term. How long the protection lasts. It may be shorter than the loan, in which case a replacement is required.
- Provider. The bank or dealer that sells the cap and owes the payments.
The borrower still owes the full loan payment every month; Fannie Mae's FAQ states that "the Borrower is always obligated to make the full payment required under the Loan Documents." And cap proceeds usually go straight to the servicer. Fannie Mae's FAQ says Fannie Mae usually requires the provider to pay the servicer directly, and Freddie Mac's Guide requires cap payments to be made to a trust account of the seller as servicer unless Freddie Mac directs otherwise.
What lenders specify
Strike rate
The strike sets the ceiling on debt service, so lenders tie it to coverage. Fannie Mae's 2019 cap requirements table says the SARM strike "must not exceed the rate that produces the minimum Underwritten DSCR" for the loan's pricing and underwriting tier. The current SARM product page underwrites coverage at a maximum note rate, defined as the investor spread, guaranty fee and servicing fee plus a minimum cap strike rate set by Fannie Mae, and lists a 1.05x minimum DSCR on that basis.
In plain terms: the lender assumes the index goes to the strike, adds the margin, and checks that net operating income still covers the resulting payment. A lower strike means more protection and a more expensive cap.
Term
Fannie Mae's SARM page requires an initial cap of at least 5 years, and its FAQ says, "Fannie Mae does not allow 1-year Interest Rate Caps at this time." For 7- and 10-year SARM loans in structured transactions, the product page describes cap terms on a 3-3-1 or 3-3-3-1 schedule.
Bridge loans often have shorter initial terms with extension options; check your term sheet. Before closing, read the extension conditions for any requirement to buy a new or extended cap, because that purchase happens at whatever price the market sets on the extension date.
Provider rating
Fannie Mae requires borrowers to use providers on its approved list. Its 2023 FAQ sets minimum ratings of A issuer or senior debt (or A-1 short-term) from S&P, or A2 (or P-1 short-term) from Moody's, and says Fannie Mae will notify lenders and providers if a downgrade affects eligibility. Freddie Mac's Guide states that if a third-party cap is required, "the cap provider, agreement and term must be acceptable to Freddie Mac."
Worked example: what the cap does to debt service
Assume a $12,000,000 floating-rate loan, interest-only, with a 2.40% margin, a 4.00% strike and a $12,000,000 notional. Interest is calculated on a 30-day period at actual/360, and annual figures are 12 such periods (a full 365-day year at actual/360 runs about 1.4% higher). The property's net operating income is $850,000 a year. All of these are illustrative assumptions, not market quotes.
| 30-day index | Loan rate | Interest for 30 days | Cap payment to servicer | Net cost to property | DSCR, net (annualized) | DSCR without a cap |
|---|---|---|---|---|---|---|
| 3.50% | 5.90% | $59,000 | $0 | $59,000 | 1.20x | 1.20x |
| 4.00% | 6.40% | $64,000 | $0 | $64,000 | 1.11x | 1.11x |
| 4.60% | 7.00% | $70,000 | $6,000 | $64,000 | 1.11x | 1.01x |
| 5.50% | 7.90% | $79,000 | $15,000 | $64,000 | 1.11x | 0.90x |
The arithmetic for the 4.60% row:
- Interest: $12,000,000 × 7.00% × 30 / 360 = $70,000
- Cap payment: $12,000,000 × (4.60% − 4.00%) × 30 / 360 = $6,000
- Net cost: $70,000 − $6,000 = $64,000, the same as the payment at a 6.40% all-in rate
- Annualized net cost: $64,000 × 12 = $768,000, and $850,000 / $768,000 = 1.11x
Above the strike, net debt service flattens at $64,000 a month. Without the cap, coverage falls below 1.0x once the index passes about 4.68% on this 12-period basis. That ceiling is what the lender requires the cap to protect, and it is why the strike and the coverage test are linked. You can rerun these figures at your own NOI and margin with the DSCR calculator.
What drives the price of a cap
A cap is an option, and the premium is typically paid upfront. The main inputs are:
- Strike relative to expected rates. The closer the strike is to where the market expects the index to be, the more likely the cap pays, and the more it costs.
- Term. A longer cap covers more periods and costs more.
- Notional. Cost scales with the balance being protected.
- Rate volatility. Higher expected volatility raises the value of the option.
Because the same inputs move over time, the price of a replacement cap two or three years into a loan can be very different from the price at closing. This is the risk the replacement reserve is meant to absorb.
Replacement cap reserves
When the loan outlasts the cap, the lender wants cash on hand to buy the next one. Fannie Mae's current Guide sets out the mechanics:
- Monthly funding for a 5-year cap. Section 1807.06 (effective October 26, 2026) says that if the initial cap term is 5 years, the borrower funds the reserve "with each monthly Mortgage Loan payment during the term." The first 6 months of deposits are based on the estimated cost of a 5-year replacement cap at the initial strike.
- Longer initial caps. If the initial cap runs more than 5 years, monthly deposits must begin no later than 5 years before it expires.
- Full funding at closing for some SARM loans. Section 1105.03 (effective September 28, 2026) says that if the initial cap term is less than the SARM loan term, the borrower must fully fund the reserve on the origination date and escrow at least 110% of the current replacement cap cost.
- Six-month reviews. Section 1807.07 requires the servicer to evaluate the reserve every 6 months. If the replacement cost has increased, the monthly deposit goes up; if it has decreased, the deposit is not adjusted.
- Reset and leftovers. When a replacement cap is bought, the reserve cycle resets to the new cap's term, and any amount left in the reserve funds the next reserve. The SARM product page adds that replacement cap escrows cannot be held for longer than 3 years.
Fannie Mae's FAQ addresses the downside. Asked whether forbearance is available if a replacement cap is "economically unavailable," the answer is "No," and it states that Fannie Mae does not provide waivers on interest rate caps at this time.
Worked example: sizing and re-sizing the reserve
Fannie Mae's Guide gives this example: if a 5-year replacement cap at a 6.00% strike is estimated to cost $140,000, the monthly reserve for the first 6 months is $140,000 / 60 = $2,333.33.
Now assume that at the 6-month review the estimated replacement cost has risen to $182,000. The reserve holds $2,333.33 × 6 = about $14,000. Spreading the remaining $168,000 over the 54 months left gives a new deposit of $168,000 / 54 = $3,111.11 a month, an increase of $777.78. The Guide requires the increase but does not prescribe this formula; the servicer's method in your loan documents controls, so treat this as an illustration of scale.
If the same loan were a SARM with a cap shorter than the loan term, Section 1105.03 would instead require funding at closing of at least 110% × $140,000 = $154,000.
Planning points for sponsors
- Underwrite at the strike. Run coverage at the strike plus the margin, plus any monthly cap reserve, and confirm the property clears the lender's minimum with room to spare.
- Budget the reserve as debt service. A rising replacement cost increases the monthly payment even if the index does not move. For covenant purposes, ask whether the reserve deposit counts in the debt service used for DSCR or cash management tests. Our guide to loan covenants and cash sweep triggers covers how those tests are drafted.
- Read the extension conditions. On a bridge loan, an extension can require a new cap at a strike that still meets the lender's coverage test. If rates and volatility are higher at that date, the purchase can take meaningful cash.
- Plan the exit alongside the cap. A cap limits the payment while the loan is outstanding, and the maturity still has to be planned. Sponsors moving from a floating-rate bridge to fixed-rate debt should map the refinancing timeline against the cap expiration so they are not buying protection they will not use. For background on how SOFR-based pricing compares with prime-based loans, see SOFR vs. prime.
Bottom line
A rate cap turns an open-ended floating rate into a capped one, and lenders set its strike so the property still covers debt service at the ceiling. The upfront premium is only part of the cost. Replacement reserves are re-priced every 6 months under Fannie Mae's rules, increases are passed through, decreases are not, and Fannie Mae's FAQ says forbearance is not available if a replacement cap is economically unavailable. Sponsors who underwrite at the strike, budget for reserve increases and read the extension conditions before closing are in the best position to carry floating-rate debt through a full cycle.