Mortgage ARM caps: What to know
Quick insights
- Adjustable-rate mortgages (ARMs) come with variable interest rates, which fluctuate after an introductory period.
- Mortgage ARM caps put limits on how much the variable interest rate can rise and fall.
- Three types of mortgage ARM caps exist, including the initial adjustment cap, the subsequent adjustment cap and the lifetime adjustment cap.
Buying a house with an adjustable-rate mortgage (ARM) means your interest rate can change over the life of the loan. The rise and fall of the variable rate can push your monthly payment up and down. But the interest rate caps attached to the loan limit how high or low the interest rate can go.
This guide lays out what borrowers should know about interest rate caps in the context of ARMs.
What are rate caps with an adjustable-rate mortgage?
Rate caps with an adjustable-rate mortgage put limits on how high or low your interest rate can go during an adjustment. After your introductory interest rate expires, your lender will adjust the interest rate on a predetermined schedule within the bounds of the rate caps set out in your loan contract.
Within an ARM, rate caps protect homeowners from sudden or drastic payment increases after a rate adjustment. During each adjustment, the homeowner will know in advance exactly how high the interest rate could rise. This can help borrowers budget for fluctuations in their monthly payment.
Types of ARM rate caps
When signing up for an ARM, borrowers can find details about the different rate caps in their loan documents. Understanding these rate caps can give you more peace of mind around potential increases to your monthly payment.
The three types of ARM caps include:
Initial adjustment cap
The initial adjustment rate cap limits how much the interest rate can change during the first adjustment. After the introductory fixed-rate period, which often lasts several years, this initial adjustment cap comes into play.
Many lenders set the initial adjustment rate cap at either two or five percentage points higher or lower than the initial interest rate of the fixed-rate period.
Subsequent adjustment cap
For subsequent interest rate adjustments during the loan’s term, this cap indicates how much the interest rate can increase or decrease.
It’s common for the subsequent adjustment cap, sometimes called the periodic adjustment cap, to be one or two percentage points below the previous level. These adjustments may occur every six to 12 months, varying based on the loan details.
Lifetime adjustment cap
The lifetime adjustment cap indicates how much the interest rate can rise or fall over the entire loan term. Typically, the lifetime adjustment cap is five percentage points above or below the starting rate, but some lenders may include higher or lower lifetime adjustment caps.
This lifetime cap gives you an idea of how high the interest rate might rise.
ARM rate cap example
Let’s say a borrower takes out a 7/6 adjustable-rate mortgage with a 7% initial interest rate. With a 7/6 ARM, the interest rate is fixed for the first seven years, then it will adjust every six months following the initial adjustment. If this loan has a 2-2-5 rate cap structure, which involves an initial, subsequent and lifetime cap, here’s how the interest rate changes could play out:
- Initial adjustment rate cap: The initial adjustment rate cap is set at 2%, which means the lender can adjust the loan by a maximum of 2%. In this case, the rate might rise to 9%, fall to 5% or land somewhere in between after the seven-year introductory rate.
- Subsequent adjustment rate cap: If the initial adjustment pushed this borrower’s interest rate to 8%, this subsequent adjustment could push the rate higher or lower by up to 2%. In this case, the rate might increase to 10%, fall to 6% or remain somewhere in between.
- Lifetime adjustment cap: In this example, the lifetime adjustment cap means the borrower won’t see their rate rise or fall by more than 5% from the initial interest rate. This means the rate might rise to 12%, fall to 2% or stay somewhere in the middle.
Benefits and risks of an ARM
The fluctuations in an ARM’s interest rate come with pros and cons for homeowners. Explore both sides below:
Pros
- Relatively low introductory rate: ARMs may offer relatively low rates during the introductory period. This can mean an affordable mortgage payment for a while.
- Monthly payments could fall: If interest rates drop, your monthly mortgage payment could shrink.
- Rate caps mitigate risks: Rate caps limit how high an ARM’s interest rate can climb.
Cons
- Monthly payments might increase: If interest rates rise, your monthly payment could rise and put pressure on your budget.
- Complex loan: The rising and falling interest rates make keeping track of your loan details more complex than managing a fixed-rate loan.
- Instability: With changing monthly payments, an ARM can add instability to your financial situation.
How to compare rate caps when choosing an ARM
Before moving forward with a particular ARM, keep the following details in mind:
- Get familiar with the different options: ARMs come in different styles. Start by exploring the various loan options to find one that best suits your needs.
- Look for rate caps: When exploring ARM rates, look for the maximum amount the interest rate may rise or fall.
- Calculate the highest possible payment: Run the numbers to determine how high your monthly payment might rise. If this higher monthly payment won’t suit your budget, then it might not be the right loan for your situation.
In summary
When exploring your mortgage loan options, understanding the rate caps attached to adjustable-rate mortgages can help you make a more informed choice. Take time to consider all of your mortgage options before committing to an ARM with rate changes built in.
