Understanding Caps on Adjustable Rate Mortgages
The danger of an adjustable-rate mortgage is that interest rises and falls periodically. You may be comfortable paying a certain amount each month, only to watch that figure increase unexpectantly.
But at least these increases are controlled and limited.
Virtually all adjustable-rate mortgage products, from the traditional to the option-payment and interest-only varieties, feature caps that limit how much the interest rate - and, therefore, your monthly mortgage payment - can be increased when your rate is adjusted.
These rate caps are important because they protect you from unlimited higher payments, no matter what is going on in the local or national economy.
So, what are initial, periodic and lifetime caps?
As explained by Lending Tree and other loan experts, the most common ARM caps are the “initial cap,” “periodic cap” and “lifetime cap.”
- The initial cap limits how much the interest rate can be increased the first time your mortgage faces a reset.
- The periodic cap limits how much the interest rate can be increased each subsequent adjustment.
- The lifetime cap sets a maximum amount by which the interest rate can be increased as long as you keep the loan.
Not all adjustable rate home loans possess an initial cap that’s different than the periodic cap. If there is no initial cap, the periodic cap applies to the first adjustment as well as to any subsequent adjustments.
How adjustable-rate caps work
The adjustment period is determined by your type of ARM. For example, a “5/1” ARM means the first adjustment will occur five years after the loan was originated; subsequent adjustments will occur annually after that.
When the loan payment is adjusted, the lender adds a set amount called the “margin” to a specified market rate called the “index” to figure out the new interest rate on your loan. The index is often the LIBOR (London Inter-Bank Offer Rate) or the one-year U.S. Treasury interest rate.
If the index plus the margin results in a higher interest rate than either the current rate on your loan plus the initial or periodic cap, as applicable, or the introductory rate plus the lifetime cap, your rate will be limited to the capped (i.e., lower) amount.
For example: you have a 5/1 ARM with an introductory interest rate of 3 percent, a margin of 2.5 percent and an initial cap of 4 percent. Five years after you obtained this home loan, the index stood at 5 percent. At your first adjustment, your new, fully indexed rate would be 7.5 percent:
Index: 5 percent
Margin: 2.5 percent
Fully indexed rate: 7.5 percent
But the periodic cap would limit the interest rate at your adjustment to 7 percent:
Introductory rate: 3 percent
Periodic cap: 4 percent
New interest rate: 7 percent
As a result, the adjusted interest rate on your ARM after five years would be 7 percent (the capped rate), NOT 7.5 percent (the fully indexed rate).
Mortgage documents disclose caps
The caps on your ARM, along with the adjustment periods, margin and index, should be disclosed in the loan documents that you signed when you obtained your mortgage. If you obtained your loan through a mortgage broker, he or she also should be able to explain the caps and other rules of your ARM in full detail.