DEFINITION of 'Annual Cap'

A clause found in the contract of an adjustable-rate mortgage (ARM) that limits the possible increase in the loan's interest rate to a certain amount each year. The cap is usually defined in terms of rate, but the dollar amount of the principal and interest payment can be capped as well. Annual caps are designed to protect borrowers against a sudden and excessive increase in the amount of their monthly payments when rates rise sharply over a short period of time.

BREAKING DOWN 'Annual Cap'

A loan with an annual rate cap will only increase by so much in terms of percentage points regardless of how much rates actually rise. A 5% ARM with a 2% cap can only adjust to 7%, 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.

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