When getting an adjustable rate mortgage (ARM), it can be a little scary not knowing what your interest rate will be for the term of the loan. What if rates skyrocket and push your payment up too high for you to pay? A cap on the interest rate is a protection against that.
Caps refer to a legally required maximum on how much the interest rate of an ARM can increase over the life of the loan. This is expressed in basically two ways. First, there is an overall cap that limits the interest rate for the entire life of the loan. In other words, over the full time period of the loan, the interest rate of the loan can only go up so much. There is a predetermined rate that the interest rate of the ARM cannot exceed. The other way this is expressed is the periodic cap, which limits how much the interest rate can increase at each adjustment period, meaning that your interest rate is not going to jump 5 points after one year. This factor is probably the most important since it has more of an immediate effect on your monthly mortgage payments.
The interest rate of an ARM is tied to an index. An index is a published interest rate against which lenders measure the difference between the current interest rate on an ARM and that earned by other investments. For example, the lender can compare the current rate on the ARM with the monthly average interest rate on loans closed by savings and loan institutions. Using this difference, the interest rate on the ARM is adjusted up or down.
Say the index rate rises from 2.5 percent to 5.5 percent during an adjustment period. That would make the interest rate of 4.5 percent rise to 7.5 percent. However, a 2 percent cap keeps the interest rate at 6.5 percent. This keeps the borrower from having too great a jump in his/her rate.
However, this can affect your interest rate in another way. If your cap keeps your interest rate below the index, then your rate can rise even if interest rates are falling. Your rate on your ARM will have to play catch-up so that means your rate will go up until it is where it should be according to the index. Generally, interest caps are a good thing and provide some security if you choose to get an ARM.