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An annual ARM cap is a clause in the contract of an adjustable-rate mortgage (ARM) that limits the possible increase in the loan's interest rate during each year. The cap, or limit, is usually defined in terms of rate, but the dollar amount of the principal and interest payment may also be capped.
Annual caps are designed to protect borrowers against a sudden and excessive increase in their monthly payments when rates rise sharply over a short period of time.
With an ARM, the initial interest rate is fixed for a period of time—five years, for example, in the case of a 5/1 ARM—after which it resets periodically based on current interest rates every year (i.e., the "1" in the 5/1). ARMs also typically have lifetime rate caps that limit how much the interest can increase over the life of the loan.
ARMs with a capped interest rate have a variable rate structure, which includes an indexed rate and a spread above that index. There are several popular indexes used for different types of ARMs, such as the prime rate or the federal funds rate. The interest rate on an ARM with its index is an example of a fully indexed interest rate. An indexed rate is based on the lowest rate creditors are willing to offer. The spread or margin is based on a borrower’s credit profile and determined by the underwriter.
The annual interest rate of an ARM loan with an annual cap will only increase as much as the terms allow in percentage points, regardless of how much rates may actually rise during the initial period. For example, a 5% ARM fixed for three years with a 2% cap can only adjust to 7% in the fourth year, even if rates increase by 4% over the initial fixed term of the loan. A loan with a dollar cap can only increase by so much as well, although this type of cap can lead to negative amortization in some cases.
The ARM's interest rate cap structure outlines the provisions governing interest rate increases over the term of the loan.
ARMs have many variations of interest rate cap structures. For example, let's say a borrower is considering a 5/1 ARM, which requires a fixed interest rate for five years, followed by a variable interest rate that resets every 12 months.
The borrower is offered a 2-2-5 interest rate cap structure for the 5/1 ARM. The interest rate cap structure is broken down as follows:
So, let's say the fixed rate was 3.5%, and the rate was adjusted higher by 2% during the initial incremental increase to 5.5%. After 12 months, mortgage rates rose to 8%; the loan rate would be adjusted to 7.5% because of the 2% cap for the annual adjustment. If rates then increased by another 2%, the loan would only increase by 1% to 8.5% because the lifetime cap is five percentage points above the original fixed rate.
ARMs often allow borrowers to qualify for larger initial mortgage loans because they lock in a lower payment for a period of time. Users of an ARM can benefit when interest rates decrease, lowering the annual interest rate paid. Conversely, when interest rates rise, ARMs become more expensive and can increase well beyond what a fixed-rate mortgage would have been.
For instance, if a buyer takes out an ARM at 3.5% at three years fixed and rates increase 4% during that period, this initial annual rate increase will be limited to the annual cap. However, in subsequent years, the rate may continue to increase with each reset period, eventually catching up with rising market interest rates.
Eventually, a 3.5% ARM, which initially was competitive with a 4.25% fixed rate, could be significantly higher. The interest rate risk associated with ARMs is why borrowers often switch to a fixed-rate loan when rates are rising. However, the borrower may ultimately pay more for having used the ARM. As a result, it's important to find a mortgage lender that has extensive experience with adjustable-rate mortgages.
The risk with adjustable-rate mortgages (ARMs) is that the loan's interest rate can rise when market rates increase since it's a variable rate loan. As a result, an ARM's monthly payment can increase over the years as rates rise. Borrowers must consider whether they can afford the higher monthly payment associated with increased market rates following the initial fixed-rate period.
An ARM cap is the maximum amount an interest rate can rise after the initial fixed-rate period expires on an adjustable-rate mortgage (ARM). For example, if the ARM's initial rate period was fixed at 4% with an annual cap of 2%, the maximum rate that the ARM could adjust to is 6% following the end of the fixed-rate period.
Annual ARM caps help protect borrowers from a rapid rise in market interest rates by establishing a maximum annual rate adjustment. So, if your ARM had an annual cap of 2%, regardless of how high interest rates moved, the maximum adjustment would be 2% added to the initial rate. ARM caps also help protect borrowers from an excessive rise in their monthly payments.
Annual ARM caps protect borrowers from a rapid rise in market interest rates by limiting the possible increase in the loan's interest rate each year. No matter how high interest rates moved that year, the maximum adjustment would be the annual ARM cap rate. However, the cap could also be established as a dollar amount of the monthly payment.