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Cap

An interest rate cap is a risk management tool for lenders and borrowers. It sets an upper limit on a variable rate loan or mortgage interest rate. A major type of loan using an interest rate cap is an adjustable-rate mortgage (ARM). 

 With ARMs, there are three types of caps: the initial adjustment rate cap, subsequent adjustment cap, and lifetime adjustment cap. The initial adjustment cap establishes how much the interest rate can rise after the fixed-rate period of the mortgage. The subsequent adjustment cap limits the interest rate rise for the remainder of the loan. The lifetime adjustment cap sets the interest rate upper limit.

For example, if the opening rate is 4.5% with an initial adjustment rate cap of 2%, the most the interest rate can move is to 6.5%. If the subsequent adjustment cap limit is 1%, then if the reference rate (perhaps the Libor rate) continues to rise, each follow-on adjustment can only increase a maximum of 1%. If the lifetime adjustment cap is 8%, the mortgage interest will not rise above 8%.

Adjustable-rate mortgages can also have a monthly payment cap. That means if the rate continues to rise and the resulting payments reach the payment cap, the payment will remain at the cap. Of course, the amount of principal paid will decline with each payment as the interest payment increases.

The advantage of an interest rate or payment cap is that it offers a degree of certainty for borrowers in expected payments, at least within a range. For lenders, it provides security when interest rates are expected to rise.