Interest Rate Caps: What Are They And How Do They Work?

An interest rate cap sets the limit on how high an interest rate can rise. As a borrower with a variable-rate loan, understanding how this cap impacts your loan can have a major impact on your financial plans.

What Is An Interest Rate Cap?

An interest rate cap limits how much the interest rate attached to a variable-rate loan product can rise. As a homeowner, interest rate caps come into play if you opt for an adjustable-rate mortgage (ARM).

Depending on the specifics, an interest rate cap can include an overall limit for how high the interest rate can rise and limit how much the interest rate can adjust during adjustment periods. In either situation, an interest rate cap protects the borrower from unrealistic interest rate increases.

Importantly, a cap rate is different from an interest rate cap. Cap rates are used by real estate investors when evaluating the financial viability of a property.

Interest Rate Caps Vs. Interest Rate Floors

Interest rate caps represent a maximum interest rate. In contrast, an interest rate floor indicates how low a variable rate can fall. In uncertain economic times, market rates can exhibit extreme volatility. With that, interest rate caps and interest rate floors protect both the borrower and the lender from unrealistic rates.

Types Of Rate Caps

Not all rate caps are created equally. Instead, different kinds of rate caps impose different limitations on variable-rate loans. Here’s a closer look at the different types of rate caps.

• Initial adjustment rate cap: The initial adjustment rate cap indicates how much an interest rate can rise during the first adjustment.
• Subsequent adjustment rate cap: The subsequent adjustment rate cap, or periodic cap, sets a limit for how much an interest rate can increase from one adjustment period to another.
• Lifetime adjustment rate cap: The lifetime adjustment rate cap indicates how much an interest rate can rise or fall over the entire loan term. As a borrower, this might represent the most important cap because it indicates how high your interest rate might rise.

How Do Interest Rate Caps Work?

An interest rate cap works by controlling how much a borrower’s interest rate can rise in an adjustment period. A rate cap can protect you from a continuously climbing mortgage rate.

The market conditions, including the secured overnight finance rate (SOFR), have a big impact on interest rate caps.

While mortgage lenders can set interest rate caps, there are some general estimates to consider. The initial adjustment cap is commonly 2% or 5%. Additionally, the subsequent adjustment rate cap is typically 2%. Finally, the lifetime adjustment cap is often 5% or 6%.

Interest Rate Cap Example

Taking on an adjustable-rate mortgage means that your interest rate can change over time. However, there are specific parameters that the lender must follow when changing your interest rate.

Here’s how it works:

Let’s say that a borrower has a 5/1 ARM. This means that the borrower enjoys a fixed interest rate for 5 years. But after the fixed-rate period, the interest rate will change every 12 months. If the borrower has a 2/2/5 interest rate cap, the potential rate changes would be limited by the following:

• Based on the initial adjustment rate cap of 2%, the interest rate can only change by 2%. For example, if the initial fixed-rate was 4%, the new interest rate could be as high as 6%.
• Next up, the subsequent adjustment rate cap of 2% means that later interest rate changes can only swing 2%. For example, if the interest rate was 5% before the rate adjustment, it could rise to 7%.
• Finally, the lifetime adjustment cap rate of 5% limits how high the rate can rise. In this example with an initial interest rate of 4%, the highest potential interest rate would be 9%.

As a borrower shopping of an ARM, it’s essential to run the numbers to determine whether you can afford the loan. If you wouldn’t be able to cover the worst-case scenario payment, taking on an ARM with those rate caps might not be the right move for your finances. Consider opting for a fixed-rate mortgage or an ARM with more favorable rate caps. It may be best to talk to a financial advisor or loan expert to learn more about your options.

Interest Rate Cap FAQs

You have questions about interest rate caps. We have answers.

What is interest rate capping?

Interest rate capping happens when there is a limit to how much an interest rate can rise. If you take out a variable-rate loan, the interest rate cap will be defined before closing.

How do interest rates affect rate caps?

Interest rates are closely tied to rate caps. If mortgage interest rates rise, rate caps on adjustable-rate mortgages also rise.

What are the pros and cons of an interest rate cap agreement?

The advantages of an interest rate cap include protection from unrealistic interest rate increases and the possibility of paying less in interest if interest rates fall. But the disadvantages include heightened uncertainty for your budget and the possibility of paying more in interest than a fixed-rate loan.

What does a 2/5/5 rate cap mean?

The first 2 represents the initial cap, or the limit on how much your interest rate can increase during the first adjustment. The first 5 represents the periodic cap, which limits how much your rate can increase from one adjustment period to the next. And the final 5 represents the lifetime cap, which indicates how much your rate can increase or decrease over the life of the loan.

The Bottom Line

An interest rate cap offers some protection to homeowners with an adjustable-rate mortgage. Without an interest rate cap in place, there is no limit to how high your interest rate can rise. Since interest rates are relatively volatile, closing on a home loan without a rate cap in place is a risky choice.

If you’re interested in purchasing a home with an ARM, take the time to learn more about adjustable-rate loans before getting started on the mortgage approval process.