Interest Rate Cap: What Is It And How Does It Work?
When you take out a loan or other type of financing, you’ll need to pay interest. Many loans have fixed APRs, but others, such as credit cards and mortgages, come with adjustable figures. If you’re buying a home, you’ll want a capped interest rate mortgage, here’s why.
Interest Rate Cap: A Simple Definition
Simply put, this cap is the ceiling in which your APR can’t climb over. Limits are applied to all variable financing types. If you have or are considering an ARM, you’ll want to pay particular attention to the caps as defined in your borrowing document.
These caps restrict how high the APR on your lending product can go and limit the incremental increases that are part of your repayment. Without ceilings, and depending on what happens with the economy, your payments could become impossible to bear.
How Do Interest Rates Work?
When you secure financing, it comes at a price. This price of accessing temporary funds is the interest the lender charges. If you have an excellent credit score, the lender will charge you the lowest amount possible. If your credit isn’t so great, or you don’t have much financial history, the lender will charge you a higher amount. Your monthly payments are a combination of the principal (the original amount you borrowed) and the loan’s cost.
Three players are involved in determining the prevailing interest margin: the Federal Reserve’s “fed funds rate,” investor demand for U.S. Treasury notes and bonds, and the banking industry.
Fixed Rate Vs. Variable Rate
The cost of financing can be fixed or variable. Additionally, a hybrid is also possible whereby a portion of the loan is fixed while the remainder is variable. Interest rate capping on a 5/1 ARM means that the amount you pay for the funds is set for the first five years before interest is adjusted every subsequent year thereafter.
- APR stays the same for the life of your loan
- Common examples include mortgages, auto loans, and personal loans
- If the margin drops, your monthly payment doesn’t change
- Conversely, if the margins spike, you still make the same monthly payment
- It’s easy to plug the monthly payment into your annual budget
- This type of financing protects you from the spikes but prevents you from taking advantage of a drop in prices
- Amount is adjusted relative to the changes in market benchmarks
- Monthly payments aren’t predictable over the life of the loan
- Examples include personal loans and mortgages
- Rising lending prices make your loan more expensive
- Carries a higher risk of monthly payment increases even with an interest cap
- Can be useful if you plan to repay the loan quickly or are willing to gamble that prevailing rates will stay low
Why Do You Want Rate Caps?
It’s essential to recognize that your adjustable-rate financing could become unaffordable without any cap in place. These types of loans often offer attractive initial APRs relative to fixed-rate lending products.
If you plan to sell your home or refinance, an ARM mortgage may be attractive. However, if you intend to stay in your home for the length of your lending product, that early low APR period could be easily wiped out by a spike in the accompanying market benchmarks used to set the figure.
In a volatile economy, rising lending cost margins could result in your inability to make your repayments. Therefore, it’s important to keep in mind that the rate caps are set high and don’t provide total protection from unpredictable markets.
How Does Capped Interest Rate Work On A Mortgage?
The most popular ARMs involve three separate caps:
- The initial limit sets the maximum interest change for the first adjustment
- The periodic limit sets the maximum limit the amount can change each adjustment period
- The lifetime limit sets the maximum amount
ARM mortgages tend to be 3/1, 5/1, 7/1, or 10/1.
As an example, consider a 5/1 ARM. The initial rate is 3.75%
- Initial limit set at 1.5%: During the first adjustment period, the APR can fall to 2.25% or rise to 5.25%
- Periodic limit set at 2%: Assuming the APR went to 5.25% during the first period, the amount can rise to 7.25% or fall to 3.25%, and in the following periods, the margin can adjust by up to 2% from the amount set in the previous period
- Lifetime limit of 10%: The interest on your ARM is capped at 13.75%, no matter what happens in the market
The Bottom Line
In most cases, fixed financing is the best option. Although, sometimes you don’t have a choice. A cap keeps the interest on an ARM manageable. It’s especially important to be aware of these margins when pursuing a mortgage since you could be making payments for 30 years.
Bear in mind that caps establish ceilings and frequency, but the interest will still rise. It’s best to imagine the worse-case outcome when determining if you can afford the loan.