Definition
Caps are limitations, particularly on the extent to which interest rates or payments can change associated with Adjustable-Rate Mortgages (ARMs). These limitations protect borrowers from drastic changes in their mortgage payments. There are three primary types of caps:
- Annual Adjustment Cap: This places a ceiling on the amount the interest rate can change within a single year.
- Life-of-Loan Cap: This sets a maximum limit on how much the interest rate can change over the entire term of the loan.
- Payment Cap: This restricts how much the monthly payment can change from year to year.
Examples
Annual Adjustment Cap: If you have an ARM with a 2% annual adjustment cap, your interest rate cannot increase or decrease by more than 2% per year, even if market rates rise or fall significantly.
Life-of-Loan Cap: With a 5% life-of-loan cap on a 30-year ARM, if your starting interest rate is 3%, the highest it can go over the loan’s lifespan is 8%.
Payment Cap: A payment cap might limit your monthly payment increase to 7.5% per year. So, if your monthly payment starts at $2,000, your payment cannot exceed $2,150 the following year.
Frequently Asked Questions
What is the purpose of a cap in an adjustable-rate mortgage?
Caps protect borrowers from significant rate increases, ensuring that their payments remain manageable even if market interest rates rise.
Can a cap be applied to other types of loans?
While caps are most commonly associated with ARMs, they can also apply to other types of loans with variable interest rates.
Are all ARMs subject to caps?
Most ARMs include some type of cap, but the specifics can vary by lender and loan product.
How often can the interest rate change in an ARM?
Interest rates in ARMs typically adjust annually, though the specific adjustment period can vary depending on the loan agreement.
What happens if interest rates drop? Will my payments decrease?
If there is an annual adjustment cap, your rate will decrease according to the cap’s limit. Payment caps may limit how much your payments can decrease.
Related Terms
Adjustable-Rate Mortgage (ARM)
A type of mortgage with an interest rate that periodically adjusts depending on the changes in a corresponding financial index tied to the loan.
Fixed-Rate Mortgage
A mortgage with a fixed interest rate for the entire term of the loan.
Interest Rate Cap
A limitation on how much the interest rate can change at each adjustment period and over the life of the loan.
Mortgage
A loan used to purchase or maintain a home, land, or other types of real estate.
Online References
- Investopedia: Adjustable-Rate Mortgage (ARM)
- Bankrate: Pros and Cons of Adjustable-Rate Mortgages
- Federal Reserve: Consumer Handbook on Adjustable-Rate Mortgages
Suggested Books for Further Studies
- The Mortgage Encyclopedia: The Authoritative Guide to Mortgage Programs, Practices, Prices and Pitfalls, Second Edition by Jack Guttentag
- All About Mortgages: Insiders’ Guide to Buying, Selling, and Financing Your Home by Julie Garton-Good
- Mortgage Ripoffs and Money Savers: An Industry Insider Explains How to Save Thousands on Your Mortgage or Refinance by Carolyn Warren
Fundamentals of Caps: Finance Basics Quiz
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