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An interest rate cap is a contract that enables customers with floating rate debt to limit or "cap" their exposure to rising interest rates. Under this contract, the cap buyer is reimbursed for the amount by which the floating rate index exceeds a certain threshold. An interest rate cap can be structured to protect customers from increases in a variety of floating rate indices, including LIBOR, commercial paper, prime and U.S. treasury rates.
Typically, the buyer makes an up-front payment to purchase the cap. The cap buyer will not make any payments after that time unless the purchase is financed. In general, the longer the term of the cap and the more protection offered by the cap, the more expensive the cap will be.
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