What is an Annual Cap
Annual cap is a clause in the contract of an adjustable-rate mortgage (ARM) limiting 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 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. With an ARM, the initial interest rate is fixed for a period of time, after which it resets periodically based on current interest rates. ARMs also typically have lifetime rate caps that set limits on how much the interest can increase over the life of the loan.
BREAKING DOWN Annual Cap
The annual interest rate of an adjustable-rate mortgage 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 that is 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 Ups and Downs of an ARM
Adjustable-rate mortgages 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. At the same time of course, during a period of rising rates, ARMs can increase well beyond what a fixed-rate mortgage would have been.
For example, if a buyer takes out an ARM at 3.5% at three years fixed, if rates increase 4% during the three years, this initial annual rate increase will be limited to the annual cap. However, in subsequent years, the rate may continue to increase, eventually catching up with current rates, which may continue to climb. Eventually, a 3.5% ARM which initially was competitive with a 4.25% fixed rate, could end up being significantly higher. ARM borrowers often look to switch to a fixed-rate when rates are rising, but may still end up paying more having used the ARM.