An interest rate cap is an option to fix a ceiling or maximum short-term interest-rate payment. The contract is written such that the buyer of the cap will receive a cash payment equal to the difference between the actual market interest rate and the cap strike rate on the notional principal, if the market rate rises above the strike rate. Like any option, the buyer of the cap pays a premium to the seller of the cap up front for this right. The premium is normally stated as an annual percentage consistent with that of the strike rate.
There are two major types of interest rate caps: the interest rate guarantee (IRG), which provides protection to the buyer for a single period only, and the interest rate cap, which provides protection for an extended period of time.
Interest rate cap is the ceiling interest rate imposed on a loan designed to protect the borrower from an unacceptable rise in the interest cost of a loan.