Interest rate caps

An interest-rate cap places a limit on the amount your interest rate can increase. Interest caps come in two versions:

Periodic caps, which limit the interest-rate increase from one adjustment period to the next; and

Overall caps, which limit the interest-rate increase over the life of the loan.
-- By law, virtually all ARMs must have an overall cap. Many have a periodic cap.

Let’s suppose you have an ARM with a periodic interest-rate cap of 2%. At the first adjustment, the index rate goes up 3%. The example shows what happens.

	ARM Interest Rate	Monthly Payment
	1st year @ 10%	$ 570.42
	2nd year @ 13% (without cap)	$ 717.12
	2nd year @ 12% (with cap)	$ 667.30
	Difference in 2nd year between payment with cap and payment without = $ 49.82

A drop in interest rates does not always lead to a drop in monthly payments.
In fact, with some ARMs that have interest-rate caps, your payment amount may increase even though the index rate has stayed the same or declined.
This may happen when an interest rate cap has been holding your interest rate down below the sum of the index plus margin. If a rate cap holds down your interest rate, increases to the index that were not imposed because of the cap may carry over to future rate adjustments.

With some ARMs, payments may increase even if the index rate stays the same or declines.

The following example shows how carryovers work. The index increased 3% during the first year. Because this ARM limits rate increases to 2% at any one time, the rate is adjusted by only 2%, to 12% for the second year. However, the remaining 1% increase in the index carries over to the next time the lender can adjust rates. So when the lender adjusts the interest rate for the third year, the rate increases 1%, to 13%, even though there is no change in the index during the second year.

	ARM Interest Rate	Monthly Payment
	1st year @ 10%	$ 570.42
	If index rises 3% . . . 2nd year @ 12% (with 2% rate cap)	$ 667.30
	If index stays the same for the 3rd year @ 13%	$ 716.56
	Even though the index stays the same in 3rd year, payment goes up $49.26

In general, the rate on your loan can go up at any scheduled adjustment date when the lender’s standard ARM rate (the index plus the margin) is higher than the rate you are paying before that adjustment.
This next example shows how a 5% overall rate cap would affect your loan.

	ARM Interest Rate	Monthly payment
	1st year @ 10%	$ 570.42
	10th year @ 15% (with cap)	$ 813.00

Let’s say that the index rate increases 1% in each of the next nine years. With a 5% overall cap, your payment would never exceed $813.00—compared to the $1,008.64 that it would have reached in the tenth year based on a 19% interest rate.

Payment caps
Some ARMs include payment caps, which limit your monthly payment increase at the time of each adjustment, usually to a per­centage of the previous payment. In other words, with a 7½% payment cap, a pay­ment of $100 could increase to no more than $107.50 in the first adjustment period, and to no more than $115.56 in the second. Let’s assume that your rate changes in the first year by 2 percentage points but your payments can increase by no more than 7½% in any one year. Here’s what your payments would look like:

	ARM Interest Rate	Monthly payment
	1st year @ 10%	$ 570.42
	2nd year @ 12% (without payment cap)	$ 667.30
	2nd year @ 12% (with 7½% payment cap)	$ 613.20
	Difference in monthly payment =	$   54.10

Many ARMs with payment caps do not have periodic interest rate caps.

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