An adjustable-rate mortgage (ARM) loan has an interest rate that changes over time. This makes it vastly different from a fixed mortgage, which carries the same interest rate over the entire life of the loan.
As a result of this variable nature, ARM loans have certain features their fixed counterparts do not have. Rate caps are one of those unique features. If you are considering one of these loans, you need to understand the periodic and lifetime rate caps used with ARM loans.
Interest Rate Caps on ARM Loans
When a borrower’s mortgage payments can increase over time (as is the case with an ARM loan), there is a chance of financial hardship down the road. This hardship can occur if the monthly payments grow beyond the borrower’s ability to repay. To limit such risk, ARM loans have rate caps that control the degree to which the interest rate can rise over time. These are a common feature of adjustable-rate mortgage loans.
ARM loan interest rate caps typically apply to three aspects of the loan:
- the frequency of the interest rate change (how often it can change)
- periodic changes (how much the rate can change from one adjustment to the next)
- lifetime cap (the total change in interest over the life of the loan)
For example, an ARM loan might have any of the following types of interest rate caps in place:
- the rate adjusts every six months, typically 1% per adjustment (and 2% per year)
- the rate adjusts only once per year, and no more than 2% annually
- the rate can adjust no more than 1% in a single year
These are just three examples of interest cap scenarios. While they vary in the degree and type of limitation, they all basically do the same thing. They control, or limit, the amount to which the interest rate can change during a specific length of time.
Periodic vs. Lifetime
As mentioned earlier, there are several types of ARM loan rate caps. Periodic and lifetime caps are the two most commonly used (and most important to borrowers). Here’s the difference:
- Periodic caps limit how much the interest rate can rise from one adjustment period to the next.
- Lifetime or “life of loan” caps limit the total amount of adjustment over the full life of the mortgage. For instance, an ARM might have a lifetime cap that limits the total interest rate adjustment to 5% or 6% over the full repayment term or “life” of the loan.
It’s common for caps to have one limit for the first adjustment or periodic change, and a separate limit for all subsequent changes after that. For instance, an ARM loan might have a 5% interest rate cap on the first adjustment, followed by a 2% limit on subsequent adjustments.
ARM loan caps can also be expressed with three numbers — the initial and subsequent caps mentioned above, followed by a lifetime limit. For instance, an adjustable mortgage with a 2/2/5 rate-cap structure will limit the initial adjustment to 2%, subsequent adjustments to 2%, and lifetime increases to no more than 5%. When only two numbers are given, it usually means the initial and periodic caps are the same.
Periodic ARM loan interest rate caps affect the size of your monthly mortgage payments. Lifetime caps affect the total amount of interest you’ll pay over the full term of the loan. As a result, they are key features of your adjustable mortgage. It’s important that you understand how they work, and how they might affect you down the road.