Initial Interest Rate Cap

What is 'Initial Interest Rate Cap'

The initial interest rate cap is the maximum amount the interest rate on an adjustable-rate loan can adjust at the first scheduled rate adjustment. Interest rate caps are usually placed on mortgage rates to insulate borrowers against extreme rate jumps over the life of the loan.

BREAKING DOWN 'Initial Interest Rate Cap'

Initial interest rate caps can only be found on adjustable-rate products, like adjustable-rate mortgages, where the interest rate undergoes scheduled changes throughout the life of the loan. Fixed rate products do not have a cap because they do not adjust. The rate at the inception of the loan remains the same until the loan is paid off, or there is a change to the terms of the Note, such as during a modification or refinance.

Products like this were popular in the early 2000’s, during the subprime mortgage boom. Many homeowners quickly found themselves in trouble when their interest rates jumped after the initial fixed period. The lure of an adjustable-rate mortgage was that the initial fixed rate was generally lower than the interest rates offered on fixed rate products at the time. Borrowers were eager to take advantage of these lower rates, with the expectation that they could refinance again before their rate adjusted. The initial interest rate cap was in place to protect homeowners a large payment shock, with the expectation that the rates would slowly increase over time.

Unfortunately, the market crashed and property values plummeted, leaving many homeowners without the ability to refinance out of increasingly costly mortgage products. Many borrowers defaulted on their mortgages compounding the subprime crash.

Although initial interest rate caps still exist as added protection for borrowers who are concerned about payment shock, adjustable-rate mortgage products are far less common today.

Example of an 'Initial Interest Rate Cap'

For example, a 30-year adjustable-rate mortgage may start off with a fixed rate of 4.5 percent for the first two years. At the first adjustment period, the initial interest rate cap is 2 percent, meaning that the rate will adjust no higher than 6.5 percent and no lower than 2.5 percent. After that, the interest rate will be subject to adjustments based off whatever index was used at the onset of the loan plus the margin. The margin is the maximum spread that the adjustments won’t fluctuate beyond.

Consider for this example that the borrower has taken out a 30-year adjustable-rate mortgage that contains an initial fixed rate of 4.5 percent, a 2 percent initial rate cap and a 6 percent margin. The maximum increase the borrower could experience is 10.5 percent over the life of the loan.