Definition:
A payment cap is a limit placed on how much the monthly payment on an adjustable-rate mortgage (ARM) can increase or decrease during an adjustment period, regardless of interest rate changes.
Example:
Laura has an adjustable-rate mortgage with a monthly payment of $1,500 and a payment cap of 7%. At the next adjustment, interest rates rise significantly, but because of the cap, her payment can only increase by $105 (7% of $1,500), making her new monthly payment $1,605—even if the new rate would normally push her payment higher.
Explanation:
Adjustable-rate mortgages (ARMs) usually come with interest rates that change periodically based on market conditions. Without limits, monthly payments could rise significantly, potentially causing financial hardship. To protect borrowers, lenders use a payment cap to control how much the payment can fluctuate at each adjustment.
There are typically two types of payment caps:
- Periodic cap: Limits how much payments can change during each adjustment period.
- Lifetime cap: Limits the maximum total increase allowed throughout the life of the loan.
While payment caps protect borrowers from sudden jumps in their mortgage payments, they may also cause negative amortization if the cap prevents payments from rising enough to cover the increased interest. Negative amortization means the unpaid interest is added back to the loan balance, increasing the total amount owed.
Why is Payment Cap Important in Real Estate Transactions?
Payment caps are important because they offer buyers protection and predictability, reducing the risk of payment shock from sudden increases. For borrowers, understanding payment caps ensures they can plan financially, knowing the maximum potential increase. For sellers, buyers aware of payment caps are typically better prepared financially, making the transaction smoother and less risky. Knowing how payment caps work is essential for anyone considering an adjustable-rate mortgage.