Interest rate cap: what it means for ARMs

What is an interest rate cap?

An interest rate cap limits how much the interest rate can increase on an adjustable-rate loan. Interest rate caps are most commonly used with adjustable-rate mortgages (ARMs). They establish limits on how much the loan rate can increase initially (the first time the rate adjusts), on subsequent adjustments and over the life of the loan (the total increase).

There are three types of interest rate caps: initial adjustment, subsequent adjustment and lifetime.

One of the biggest concerns with a variable rate on a mortgage or other installment loan is how much your payment might change when the interest rate resets. A benefit to an adjustable-rate loan is the potential for your payment to decrease if rates are lower at the change date. Conversely, your payment might increase in a rising interest rate environment.

Interest rate caps protect borrowers during a rising rate environment, since they establish the maximum amount the rate can change. Because the interest rate caps are defined in your loan documents, you can do the math to determine the maximum principal and interest payment you might have to make on your loan.

If you’re concerned about the affordability of a loan payment should interest rates increase, you might be better off choosing a fixed-rate loan instead. If you already have an ARM, you might consider refinancing to a fixed-rate loan when interest rates are low or are expected to increase.

What does an interest rate cap mean for ARMs?

On an ARM, the rate stays the same for an initial period and then changes at set intervals (for example, once per year). This differs from a fixed-rate mortgage, where the interest rate never changes. Besides defining how frequently the rate changes, ARMs also include limits on how much the rate can increase each time and in total over the life of the loan; these are known as interest rate caps.

Jay Dacey, president of Jay Dacey Mortgage Team, a broker in St. Paul, Minnesota, explained that ARMs typically carry three separate interest rate caps: the initial adjustment cap, the annual (aka, periodic or subsequent) cap and the lifetime cap.”

These three interest caps provide homeowners with ARMs protection against future interest rate increases.

• Initial interest rate adjustment cap: The initial adjustment cap limits the amount your rate can increase at the first adjustment period; it is often 2% to 5%. This means if your loan started at a 5% rate, the most it could increase at the first adjustment period is to a maximum of 7% to 10%.
• Subsequent interest rate adjustment cap: The subsequent cap limits how much your rate can increase at the following adjustment periods; it is most often 2%. If the cap is 2% and your rate adjusts to 7% at the first adjustment period, 9% is the highest possible rate you can subsequently have.
• Lifetime interest rate adjustment cap: The lifetime cap limits the total amount your rate can increase over the life of the loan. If you have a lifetime cap of 5% —  a common cap — and your initial rate is 5%, future increases could never take your rate higher than 10%.

As you shop for an ARM, consider both the initial interest rate and the rate caps. Even if two lenders offer you the same initial interest rate, the potential for future rate increases may be vastly different depending on the interest rate caps.

When should I consider an ARM?

You might want to consider an ARM if you plan on selling your home or refinancing your loan before the loan’s initial rate period ends, if interest rates are high when you buy your home or if the potential for a higher payment in the future doesn’t concern you.

“Homeowners should consider an ARM when they are confident they will not keep the mortgage more than a few years, or they are most concerned about the monthly payment versus the long-term risk of an adjustable rate,” said Eric Jeanette, president of the mortgage broker Dream Home Financing.

According to Jeanette, a key advantage of an ARM versus a traditional fixed-rate mortgage is the ability to receive a lower interest rate initially. “This means there will be a lower payment and the ability to stretch out your buying power,” Jeanette said.

However, one of the key concerns associated with ARMs is how much the interest rate might increase at each adjustment period. Your lender must share details about the interest rate caps with you during loan origination; you can ask the lender to calculate the highest possible monthly payment you might need to make under the loan terms.

“The standard interest rate cap for adjustable rate mortgages is 2-2-6,” said Jeanette. “This means the most the interest rate can increase at the first adjustment period is 2%, the most the rate can increase at any subsequent adjustment period is 2%, and the most the rate can increase over the life of the loan is 6%.”

Ultimately, if you don’t think your budget can support the maximum potential payment, you might want to consider getting a fixed-rate mortgage instead of an ARM.

Bottom line

Interest rate caps limit how much the interest rate on an ARM can increase initially, regularly and in total. These caps make it possible to know your maximum possible monthly mortgage payment before you decide on an adjustable-rate home loan.

Carefully review your mortgage offer before moving forward so you know each of the three types of rate caps. By carefully considering your financial situation and how your mortgage payments might change, you’ll be a better-informed borrower. If you’re unsure which mortgage is right for you, it’s a good idea to consult with a mortgage professional.