Life Cap

Posted in Finance, Accounting and Economics Terms, Total Reads: 302
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Definition: Life Cap

It refers to a cap on the interest rate of a floating rate loan over the term of the loan.


Why is it significant?

Let us begin by understanding a floating rate loan. There are two types of loan: Fixed rate loan and floating rate loan


In a fixed rate loan, the rate of interest the borrower has to pay to the lender is fixed and remains constant throughout the term of the loan.


In a floating rate loan, the interest rate varies according to some pre decided index. For instance, the interest rate could vary in accordance with the LIBOR( London Interbank Offered Rate). So let’s say the interest rate is LIBOR+100 bps meaning that 100 basis points above the LIBOR will be paid at the time of interest payment.

 

Let us say a corporate has issued a corporate bond with floating interest rate payment. Now, if there is a hike in LIBOR, the interest expense for the corporate increases. If there is a significant upward movement of LIBOR, the interest expense for the corporate will go through the roof. To avert this situation, there is a cap on the interest rate and this is why it is popular.

 

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