An adjustable rate mortgage, though offering you a more affordable payment option than a fixed-rate mortgage, is not without risk. You have a reason to worry when the fixed period is over and the rate begins to adjust according to the index it is tied to.
What if the interest rate, responding to a volatile market, soars too high, resulting into an unaffordable monthly payment?
To help relieve a borrower from what is known as a payment shock, there exist rate caps, which are limitations on the size of rate adjustments on an ARM. Caps are one of the four most important components of an adjustable-rate mortgage.
An ARM rate cap structure is typically represented by x/y/z, where ‘x’ refers to an initial rate cap, ‘y’ refers to a periodic rate cap, and ‘z’ refers to a lifetime interest rate cap. All the three are expressed in percentage points and are the three basic types of an interest rate cap.
Furthermore, there can be interest rate decrease cap and interest rate increase cap that represent the maximum allowable decrease and increase, respectively, on an ARM each time the rate is adjusted. An adjustment cap is, thus, simply a limit on how much a variable interest rate can go up or down in a single adjustment period.
An initial rate cap refers to a limit on how much the interest rate can be increased the first time it is adjusted. When there is no initial cap, then the periodic cap is applied to the first adjustment. Also, the interest rate cap structure is expressed in y/z fashion, where ‘y’ refers to initial and periodic cap, and ‘z’ refers to life cap. When expressed separately, the initial rate cap may be higher than the periodic rate cap.
After initial adjustment, the interest rate is subject o periodic adjustment, may be annually or semi-annually. A periodic cap refers to the percentage point that limits the increase or decrease of interest rate in an adjustment period. If the periodic adjustment is done every year, then you have an annual adjustment cap to limit the amount of increase or decrease.
By law, an adjustable-rate mortgage must have a lifetime cap (sometime also called an interest rate ceiling), which is the highest interest rate possible during the term of a loan. For example, if your ARM has a lifetime cap of 6% and you have started out with a 3% initial interest rate, then your indexed rate can never exceed 9%.