What is an Interest Rate Cap for ARM Loans?

Reader Question: "I am buying a home soon and I plan to use an adjustable-rate mortgage to pay for it. I'll only be in the home a few years. Can you tell me about interest rate caps on ARM loans, and how they work?"

The primary difference between a fixed-rate mortgage and the adjustable-rate mortgage (ARM) is that the rate on an ARM loan will change over time. For example, with a 5/1 ARM, the interest rate will stay the same for the first five years, and then it will adjust or "reset" once a year after that five-year period.

More often than not, the rate will increase when it resets (because average interest rates tend to rise over time). This means the size of your monthly mortgage payment will increase as well. This is where interest rate caps come into the picture. As the name implies, a cap will limit how much the rate can increase during the adjustment / reset. So, in essence, they are used to protect homeowners from excessive rate hikes.

Two Types of Rate Caps

There are two different kinds of interest rate caps, and you should understand both of them if you're considering an ARM loan:

• The annual interest rate cap limits how much it can change within a given year. This is also referred to as a periodic cap.
  
• The life-of-loan interest rate cap limits the maximum (and minimum) rate you can pay for as long as you have the loan. This is also referred to as a lifetime cap.
  

Here's the most important thing you should take away from this lesson. Some ARM loans do not have interest rate caps at all. And for the loans that do have caps, they can vary quite a bit. So if you're choosing an ARM, you need to ask plenty of questions and read all of the fine print. You need to know (A) if there's an interest rate cap on the loan and (B) exactly how the cap works.

You should also ask the lender to show you how much your monthly payment could increase at each adjustment point, based on the maximum increase allowable under the cap. It helps to see an actual dollar amount that might be incurred each month. You need to know the maximum payment you might be facing after the adjustments.

I hope this answers your question about interest rate caps and ARM loans. Good luck with your home purchase.