Cap - Caps are limits on an adjustable rate mortgage that limit the amount the payment or, more commonly the interest rate can be increased or decreased during each adjustment period (usually 6 or 12 months). Some ARMs also have a lifetime cap.

 

To illustrate rate caps, using a hypothetical 1 Year ARM as an example. Our example loan has three caps, an initial cap of 2%, a subsequent periodic cap of 1%, and a lifetime cap of 6%. It also has an initial interest rate of 5%, but will have rate adjustments each year based on the value of an interest rate index plus a margin of 1%.

For the first year of the mortgage, you are charged the initial interest rate of 5%. At the end of the first year, your new interest rate is calculated by comparing an interest rate index and a margin of 1%. In this example, the index rate is 6.5%. Adding the 1% margin brings the rate to 7.5% Because this loan has an initial rate cap of 2%, instead of being charged the full 7.5%, your new rate will only be your initial interest rate of 5% plus the initial cap of 2%, or 7%.

At the end of the second year, its time to adjust your rate again. This time the idex for your loan is 7.25%, 0.75% higher than last year's index value. That, plus the 1% margin gets your rate to 8.25%. Without caps, this is what your rate would be. Fortunately, your subsequent rate cap is 1% so your rate only rises to your current rate plus the cap, or 8%.

This continues in following years, with your rate being adjusted to the lower of the index plus margin rate or the current plus cap rate.

 

In our example, interest rates continue to rise and the index eventually reaches 10.5%. With the index at that level, adding your 1% margin would result in an 11.5% rate. Fortunately, there is a 6% lifetime cap for this loan, limiting your interest rate to the initial rate plus 6%, or 11%. No matter how high the index rises above 10%, the interest rate you pay will never go over 11%.

As you can see, rate caps protect you from a sharper than expected rise in interest rates.