Periodic Rate Caps: Protecting Borrowers in Adjustable Mortgages

What Is a Periodic Interest Rate Cap?

A periodic interest rate cap limits how much an adjustable-rate mortgage interest rate can change during one adjustment period, helping protect borrowers from sudden increases. It works with features such as lifetime caps and rate floors, while rate changes are tied to indices like LIBOR or the Treasury Average Index. Even with a cap, rates can rise over time if index and margin levels keep increasing.

Why Periodic Interest Rate Caps Matter in Adjustable Mortgages

When an adjustment period expires, the interest rate is adjusted to reflect prevailing rates which may be an upward or downward adjustment and is limited by the periodic interest rate cap. While the periodic interest rate cap is a crucial number to understand, it is only one of the figures which determine the structure on an adjustable-rate mortgage (ARM). Other significant terms for the borrower to know include:

• The lifetime cap is the maximum upper limit interest rate allowable on an ARM.
• An initial interest rate is an introductory rate on an adjustable or floating rate loan, typically below the prevailing interest rates which remains constant for a period of six months to 10 years.
• The initial adjustment rate cap is the maximum amount the rate may move on the first scheduled adjustment date.
• The rate floor is the agreed upon rate in the lower range of rates associated with a floating rate loan product.
• An interest rate ceiling which is similar to and sometimes referred to as, lifetime caps. However, an interest rate ceiling usually an absolute percentage value. For example, the contractual terms of the mortgage may state that the maximum interest rate may never exceed 15%.

How ARM Interest Rate Caps Affect Your Mortgage

Adjustable-rate mortgages come in many different types. ARMs will have descriptions that include numeric expressions of timeframes and the amount of rate increases. For example, a 3/1 ARM with an initial rate of 4% may have a cap structure of 2/1/8.

At the end of the initial three-year period, the four percent rate may adjust as much as 2%. The adjustment may be to a lower or a higher interest rate. So, after the three-year initial period, the interest charged may change to somewhere between 2 and 6%. Each year after the initial adjustment, the rate can move up or down as much as 1%. At no point is the lender able to change the interest rate above eight percent.

When each adjustment is due, the lender uses one or a combination of indices to reflect current market interest rates. The lender’s choice of an index must be shown in the initial loan agreement. Commonly used benchmarks include the London Interbank Offered Rate (LIBOR), the 12-month Treasury Average Index, or the Constant Maturity Treasury. The lender will also add a margin to the stated interest rate. Details on the amount of the margin must also be in the original loan documentation.

While lenders cannot move the rate above that cap limit, in some cases, borrowers are still responsible for rates above the cap. This situation can happen if the index plus margin would place a periodic rate above the cap. Returning to the previous example, if the lender has a 2% margin, the borrower can have an interest rate of 10%.

The Bottom Line

Periodic interest rate caps restrict how much an adjustable-rate mortgage can change during each adjustment period. Other features such as initial rates, lifetime caps, and rate floors shape overall loan behavior, with adjustments tied to indices like LIBOR plus a margin. Economic conditions can still lead to higher rates over time despite these limits.