Definition
An Adjustable-Rate Mortgage (ARM) Cap is a limit on how much the interest rate on an ARM can increase or decrease during specific periods of the loan term. These caps protect borrowers from drastic payment increases by placing restrictions on rate adjustments.
Explanation
Adjustable-rate mortgages (ARMs) start with a fixed introductory interest rate for a set period (e.g., 5 years in a 5/1 ARM) before adjusting periodically based on an index rate. Because these rates fluctuate, ARM caps prevent unlimited increases that could lead to financial strain for borrowers.
There are three main types of ARM caps:
- Initial Adjustment Cap – Limits how much the interest rate can increase after the fixed-rate period ends.
- Periodic Adjustment Cap – Limits how much the interest rate can change at each adjustment period.
- Lifetime Cap – Sets the maximum interest rate increase over the life of the loan.
For example, an ARM might have a 5/2/5 cap structure, meaning:
- 5% max increase after the initial fixed period
- 2% max increase per subsequent adjustment period
- 5% max increase over the life of the loan
Example
A borrower takes out a 5/1 ARM with a starting interest rate of 3%. The loan has a 5/2/5 cap structure, meaning:
- After 5 years, the rate could rise by up to 5% (max 8%).
- Each subsequent adjustment can increase by no more than 2% per period.
- The lifetime cap ensures the rate never exceeds 8%.