When getting an 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 common protection for you when getting an ARM. Another protection is a cap on the payment.
Interest 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 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.
Instead of limiting how much the interest rate can rise, payment caps limit how much the payment can rise. For example, say you have a 7.5 percent payment cap with a $500 a month payment. For the first adjustment period, the payment can only raise $37.50. Now the payment is $537.50. At the next adjustment it can only raise $40.31 (which is 7.5 percent of $537.50).
A payment cap may seem like a good idea, but it definitely has drawbacks. The cap may keep your payment too low to cover the interest. This results in negative amortization. That means the principal is going up instead of down. That is not a good situation. The goal of your monthly payments should be to pay down your loan, not cause it to increase.
Investigate the consequences of a payment cap on an ARM before agreeing to one. It may be better to get an interest cap, instead. See what works best for your financial situation.