Fixed, floating, and the cap you are forced to buy

Most borrowers choose between a fixed and a floating rate as if the only question is which number is lower today. The fixed borrower locks a payment for the life of the loan. The floating borrower bets that rates stay low and takes the risk if they do not. That framing is right as far as it goes, and it misses the part that actually breaks deals. A floating-rate loan usually forces the borrower to buy an interest-rate cap, a separate derivative, and the cost of that cap is a moving target the lender can make you hit again at the worst possible time.

A floating rate is a rate plus a cap you are required to buy. When rates spike, the cap that protects you gets more expensive exactly when you can least afford it.

Fixed and floating are two different bets

A fixed rate is set once and holds. The borrower trades away the chance that rates fall for the certainty that the payment never rises. Fixed-rate debt dominates long-term, stabilized lending: agency multifamily, life-company loans, most CMBS.

A floating rate moves with a benchmark. It is quoted as an index plus a spread, so a loan at “the index plus 300” pays whatever the index is today plus three percentage points. When the index rises, the payment rises with it, every month, with no ceiling unless the borrower builds one. Floating-rate debt dominates short-term, transitional lending: bridge loans, construction loans, value-add business plans that expect to refinance in a few years.

The index changed underneath everyone

For decades the index was LIBOR. It is gone, retired after a rate-rigging scandal, and the market moved to SOFR, the Secured Overnight Financing Rate. SOFR is a secured, backward-looking, near risk-free rate published daily. The mechanics of a floating loan did not change: still an index plus a spread. But any loan document, cap, or model still written against LIBOR is referencing a rate that no longer exists, and older agreements carry fallback language that converts them to SOFR on terms the borrower did not separately negotiate. Read the index definition, not just the spread.

The rate cap is the term nobody reads until it doubles

Here is the part that surprises people. A floating-rate lender does not simply accept the risk that rates rise. It usually requires the borrower to buy an interest-rate cap, a contract from a third party that pays the borrower whenever the index climbs above a strike rate. The cap protects the lender as much as the borrower: it guarantees the loan stays serviceable even if rates spike.

The cap is bought up front, for the loan term, and it is priced on what the market expects rates to do. When rates are calm and expected to stay low, a cap is cheap. When rates are volatile and climbing, a cap on the same loan can cost many multiples of what it did a year earlier. A borrower who bought a two-year cap for $150,000 can face a renewal quote of $1 million or more for the next two years. That is not a hypothetical. It is what happened across the floating-rate market when rates rose sharply, and it turned performing deals into distressed ones without a single missed payment.

How the cap sinks the deal at extension

The cap and the loan term are linked, and that link is the trap. Floating-rate loans are short, often with extension options, and the lender conditions each extension on the borrower holding a cap through the new period. So at the exact moment a stressed deal needs its extension, the borrower must go buy a fresh cap, at whatever the volatile market now charges, out of cash the deal may not have. A deal that pencils on paper can fail its extension purely on the cost of the cap it is required to carry, and the failure looks like the refinance that comes up short: a hard maturity date, a lender holding the cards, and a gap the borrower has to fund from somewhere.

The consequence to price before you sign

The rate you compare at origination is the smallest part of the decision. Fixed versus floating is really a question of who carries the rate risk and at what hidden cost. A fixed rate buries the cost of certainty in the spread. A floating rate hands you a lower headline number and a mandatory derivative whose future price you do not control, tied to an extension you may desperately need. Price the cap over the full term including every extension, not just the first purchase, and treat a required cap renewal as a scheduled capital call, because that is how it behaves. The borrower who models only the starting rate is modeling the one number that was never the risk.