Initial Interest Rate Cap

Initial Interest Rate Cap

Investopedia / Theresa Chiechi

What Is an Initial Interest Rate Cap?

An initial interest rate cap is defined as the maximum amount that 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. Because they are initial, the rate cap is subject to change after the initial period has concluded.

Key Takeaways

  • An initial interest rate cap is the maximum amount that the interest rate on an adjustable-rate loan can increase at the first scheduled rate adjustment.
  • Initial interest rate caps are put into place primarily on mortgage rates to protect borrowers from large rate jumps over the life of the loan.
  • As an initial interest rate cap is only for the first-rate adjustment, the interest rate and the cap can change after the initial period has ended.
  • Initial interest rate caps are only applicable to adjustable-rate loans, not fixed-rate loans, as fixed-rate loans have the same interest rate for the entire life of the loan.
  • Adjustable-rate mortgages were a driving force behind the subprime meltdown that led to the Great Recession in the 2000s.
  • Individuals were attracted to the low initial interest rates of the adjustable-rate mortgages but had difficulty making payments when the interest rate increased after the initial fixed-rate period.

Understanding Initial Interest Rate Caps

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 modification or refinance.

Products with variable interest rates were popular in the early 2000s 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 from 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

Take as an example, a hypothetical 30-year adjustable-rate mortgage (ARM), which may start off with a fixed rate of 4.5% for the first two years. This is lower than the current interest rate on a fixed-rate mortgage, which is 4.8%, making the adjustable mortgage appear more attractive.

At the end of the first adjustment period, the initial interest rate cap is plus or minus 2%, meaning that the rate will adjust no higher than 6.5%, and no lower than 2.5%. After that, the interest rate will be subject to adjustments based on 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.

If, when the first adjustment period hits and mortgage rates have decreased, the borrower will benefit from a lower interest rate. Now, if interest rates have increased, the borrower will be at a disadvantage as their interest rate has gone up and so has their monthly mortgage payment. If borrowers aren't aware or able to absorb the increase in payments, an adjustable-rate mortgage can be an extremely risky option.

Consider another example where the borrower has taken out a 30-year adjustable-rate mortgage that contains an initial fixed rate of 4.5%, a 2% initial rate cap, and a 6% margin. The maximum increase the borrower could experience would then be 10.5% over the life of the loan.