Definition:
An interest rate cap is a limit on how much the interest rate can increase on an adjustable-rate mortgage (ARM) over time. It protects borrowers from dramatic spikes in their monthly mortgage payments.
Example:
Tina gets a 5/1 ARM with an initial interest rate of 4%. Her loan has a 2/2/5 interest rate cap, meaning her rate can’t increase by more than 2% at the first adjustment, 2% each year after, and no more than 5% total over the life of the loan. So, her rate can never go higher than 9%.
Explanation:
Interest rate caps are used with adjustable-rate mortgages to control how much the interest rate can change. These caps come in three main types:
- Initial Cap – Limits how much the interest rate can increase the first time it adjusts after the fixed period ends.
- Periodic Cap – Limits how much the rate can change during each adjustment period after the first.
- Lifetime Cap – Limits how much the rate can increase in total over the life of the loan.
Caps are usually written in a format like 2/2/5, where:
- The first “2” is the initial cap
- The second “2” is the periodic cap
- The “5” is the lifetime cap
This structure gives borrowers peace of mind by preventing unexpected and unmanageable increases in their housing costs.
Why is Interest Rate Cap Important in Real Estate Transactions?
Interest rate caps are important because they limit financial risk for borrowers using ARMs. They make adjustable-rate loans more predictable and safer, especially if market interest rates rise significantly. For buyers, understanding the cap terms helps in budgeting and choosing the right loan. For sellers and lenders, clear cap structures can make ARM loans more attractive and accessible.