# Accounting for an interest rate cap on a mortgage

## Overview: Accounting for Interest Rate Caps

An interest rate cap on a mortgage is accounted for as a separate derivative financial instrument, initially recognized at fair value (often the premium paid) and subsequently re-measured at each reporting date with changes in fair value reflected in the profit and loss statement. If it qualifies as a hedge under accounting standards like IFRS 9 or ASC 815, hedge accounting can be applied, allowing effective changes in fair value to be recognized in other comprehensive income. The cap is derecognized from the balance sheet when it expires, is sold, or terminated, with any resulting gains or losses recognized in the profit and loss statement.

Here's a general overview of how this is typically done:

**Identification and Initial Recognition**

An interest rate cap is a type of derivative, specifically an interest rate derivative, which is used to limit the maximum interest rate on a variable-rate loan.

At the inception of the cap agreement, it should be recognized on the balance sheet at its fair value, which is often the premium paid for the cap.

**Subsequent Measurement**

The interest rate cap must be re-measured at fair value at each reporting date.

Changes in the fair value of the cap are generally recognized in the profit and loss statement.

The method of measuring changes (e.g., through income statement or other comprehensive income) depends on the accounting policies adopted by the entity, such as whether it qualifies for hedge accounting under standards like IFRS 9 or ASC 815 (in the U.S.).

**Hedge Accounting**

If the interest rate cap is designated as a hedge for a recognized liability (e.g., a variable-rate mortgage), and it meets certain criteria, hedge accounting may be applied.

In hedge accounting, the effective portion of changes in the fair value of the cap can be recognized in other comprehensive income (OCI), and ineffective portion (if any) is recognized in profit or loss.

**Derecognition**

When the cap expires, is sold, or is terminated, it should be derecognized from the balance sheet.

Any resulting gain or loss should be recognized in the profit and loss statement at the time of derecognition.

This is a simplified overview, and actual accounting treatments can vary based on specific circumstances and the accounting standards applicable (such as IFRS or U.S. GAAP). It's also important to note that the specific terms of the interest rate cap and the underlying mortgage, as well as the entity's risk management strategy, can significantly influence the accounting treatment. For accurate and tailored accounting advice, consulting a professional accountant or financial advisor is recommended.

## Interest Rate Cap Calculation Example

Let's create a hypothetical example to illustrate how an interest rate cap calculation might work for a $50 million multifamily real estate deal.

Assume the following details:

- Loan Amount: $50,000,000
- Variable Interest Rate: Based on a benchmark rate (e.g., LIBOR, SOFR) plus a spread. Let's say LIBOR + 2%.
- Current LIBOR Rate: 3%
- Interest Rate Cap: Set at 5%
- Cap Premium: 0.75% of the loan amount (a fee paid upfront to purchase the cap)

The interest rate cap ensures that the interest rate on the loan will not exceed 5%, even if the benchmark rate (LIBOR in this case) rises above 3%.

**Calculating the Premium for the Interest Rate Cap**

- Premium = 0.75% of $50,000,000
- Premium = $375,000
- This premium is paid upfront to the cap provider.

**Calculating the Interest Payment Without the Cap**

- For illustration, let's assume the LIBOR rate rises to 4%.
- Total Interest Rate = LIBOR (4%) + Spread (2%) = 6%
- Annual Interest Payment = 6% of $50,000,000
- Annual Interest Payment = $3,000,000

**Calculating the Interest Payment With the Cap**

- With the cap in place, the interest rate cannot exceed 5%.
- Capped Interest Rate = 5%
- Annual Interest Payment with Cap = 5% of $50,000,000
- Annual Interest Payment with Cap = $2,500,000
- So, with the interest rate cap, the borrower saves on interest payments when the interest rate rises above 5%.

**Net Savings from the Cap**

- Interest Payment Without Cap - Interest Payment With Cap = Savings
- $3,000,000 - $2,500,000 = $500,000
- However, remember to subtract the cost of the premium:
- Net Savings = $500,000 - $375,000 = $125,000

In this example, the borrower pays a premium of $375,000 to cap the interest rate at 5%. If the LIBOR rate increases to 4% (resulting in a total interest rate of 6%), the cap saves the borrower $500,000 in interest payments, leading to a net saving of $125,000 after accounting for the premium. Keep in mind this is a simplified example; actual calculations would consider the specific terms of the cap, including its duration, and interest would typically be calculated on a monthly or quarterly basis, not annually.