What are Interest Rate Caps?


Adjustable rate mortgages (ARMs), and more recently Hybrid ARMs are some of the more risky home loans a borrower can get. The risk involved comes from the instability of the interest rate, which does not remain fixed for the entire length of the loan. Instead, the rate is variable and adjusted to better match the index rate that the interest is based on such as LIBOR or the Federal Fund Rate. Sure, Hybrid ARMs have introductory periods when the rate remains stable, but as soon as that period ends, the rate is susceptible to adjustments or “resets” at set intervals.

The fact that these Hybrid ARM products are so popular today, comes from the significantly low rate of interest during the fixed period that they each have. The problem, however, is how to handle the mortgage once that initial period ends. You see, since the interest rate starts so low, it almost always has nowhere to go but up once the rate converts into a variable structure.

Now, most borrowers will soak up the savings during the initial fixed rate period of these ARMs, and then refinance their mortgage before the rate becomes adjustable, but this isn’t always the case. So how can borrowers survive with a rising interest rate and growing monthly mortgage payments?

The answer is with interest rate caps. An interest rate cap can span a few different connotations, but in general, they are maximum amounts by which the interest rate can be adjusted on a home loan. To clarify, interest rate caps function to prevent the interest rate from spiking too high on a reset, thus causing financial hardship for the borrower. They are implemented to make sure that even after adjustments, the borrower is reasonably able to repay the debt in full.

What are Interest Rate Caps?

The term “interest rate cap” is quite versatile when it comes to home loans. Through careful consideration, they have become a staple when dealing with adjustable rate mortgages across the board. These caps are put in place with the sole purpose of lowering the risk for the borrower when the rate is to be adjusted, to ensure that it doesn’t rise unreasonably high relatively overnight.

Most Adjustable rate mortgages have set intervals between adjustments of the interest rate. In most cases, the time between adjustments is one year. In some cases, it is shorter, with adjustments taking place every 6 months (twice a year). With an interest rate that is bound to go up at each adjustment, you can imagine how quickly a borrower’s monthly mortgage payment can increase within a short period of time.

Interest rate caps provide the best solution to this problem, locking the rate into a more predictable, and by extension, manageable flow. To accomplish this, these caps are placed on the amount by which the interest rate can increase per adjustment, as well as over the overall life of the loan. The result is a much more predictable reset each adjustment period, and a guarantee of the interest never rising above a set level during the repayment period.

How do interest Rate Caps work?

As it turns out, interest rate caps work on a multi-tiered basis, in order to minimize risk of financial hardship for the borrower. Many adjustable rate loans have three different caps in place in order to meet this goal. There is typically a cap on the initial adjustment, a cap for each subsequent adjustment, and a lifetime cap for the full loan term.

Each cap has its own importance. The breakdown of what each cap is for is as follows:

  • Initial Adjustment Cap: This cap determines the maximum value by which the interest rate can be adjusted for the very first adjustment after the fixed rate period of a hybrid adjustable rate mortgage ends. The initial cap is sometimes of a different value than the subsequent caps, depending on the agreement between the lender and the borrower. Typically, for hybrid ARMs with initial fixed rate periods of 3 years or less have initial adjustment caps between 2% and 3% above the starting interest rate. Hybrid ARMs with initial fixed rate periods of 5 years or greater have initial adjustment caps between 5% and 6% above the starting interest rate.

  • Periodic Adjustment Cap: This is the cap that is in place to dictate the maximum value by which the interest rate can change per adjustment. This cap makes it so that each adjustment that takes place can only occur within the value amount set by the cap. Most commonly, periodic adjustment caps are set at either 1% or 2% for most home loans.

  • Lifetime cap: The lifetime cap, sometimes known as the interest rate ceiling, is put in place as a set maximum figure that the interest rate absolutely cannot increase beyond over the life of the loan. This means that should the interest rate rise by the set increments over the course of the loan term, and reaches the lifetime cap, it will stay locked in place for the remainder of the loan term, unless the benchmark rate gets lowered, in which case it can be reduced. The typical lifetime cap on home loans varies depending on the loan type, lender, and credit report of the borrower, but generally is set at around 5% to 6%. Still, it is not uncommon to see much higher rate ceilings.

When discussing the caps placed on an adjustable rate mortgage, the structure is often written in the style of initial adjustment cap/ subsequent adjustment cap/ lifetime cap. For example, an ARM with an initial cap of 1%, subsequent caps of 2%, and a lifetime cap of 6% would be expressed as a 1/2/6 capped loan.

A good portion of the time, the initial cap and the subsequent cap is the same value, in which case it is expressed using only the subsequent cap/ lifetime cap. This would mean that a loan with adjustment caps of 2% and a lifetime cap of 6% could be expressed as simply 2/6.

Interest Rate Floor

While borrowers with adjustable rate mortgages worry about their interest rate rising higher than they can afford over the life of their loan agreement, lenders must be concerned with the interest rate dropping well beyond what is profitable for them. Interest rate caps act as a sort of protection for a borrower, but what protection do lenders have against the volatility of the benchmark interest rate?

If you haven’t guessed already, the answer is interest rate floors. Most borrowers only concern themselves with how much the rate can rise per adjustment or in total, but the truth is that the periodic adjustment cap dictates the maximum value the interest rate can rise or fall with each adjustment. It only makes sense, the market rate fluctuates, but it isn’t supposed to be on a continuously rising trend. Within a 30-year period, the benchmark rate should fall some of the time, and the interest rate on a borrower’s ARM should be reset to match this drop.

Of course, a downward trend is always a possibility as well. This is where the interest rate floor comes in. Much like its counterpart, the interest rate ceiling, an interest rate floor is an absolute minimum value for the interest rate on an adjustable rate mortgage to drop to.

That means that no matter how low the benchmark rate drops, the interest rate on a borrower’s variable rate mortgage can only go as low as the agreed-upon interest rate floor. With a set floor in place, lenders can be sure that they don’t lose money on any ARM agreements.

Interest Rate Caps: In Review

If you’re looking to get an adjustable rate mortgage for whatever reason, it is always important to discuss the interest rate caps with your lender. Even if you plan on refinancing before the initial fixed interest rate period ends, you can never be too sure what your financial status will be in the future.

That said, having a discussion about interest rate caps when agreeing on an ARM can be a saving grace if refinancing isn’t an option down the line. The major problem that hindered the popularity of adjustable rate mortgages was always the unpredictability of what your monthly mortgage payments would look like after adjustments. While interest rate caps don’t completely solve the problem of volatility, it does make predicting how much your interest rate (and monthly payment) will increase or decrease by incredibly easier.

If you are interested in getting an adjustable rate mortgage, or simply want to learn more about interest rate caps and how they work, don’t hesitate to reach out to a home.loans expert for risk-free advisory services.

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