A life cap is the maximum amount that the interest rate on an adjustable-rate loan can increase over the term of the loan.
A life cap can be expressed as an absolute interest rate—such as a maximum lifetime rate of 12%, which is called an interest rate ceiling—or as a maximum percentage change in the interest rate from the initial interest rate on loan. When the life cap is expressed as a maximum percentage change from the initial interest rate, it can also apply to interest rate decreases.
Breaking Down a Life Cap
In dealing with adjustable-rate mortgages (ARM), typically there will be a sequence of interest rate caps that control the amount of interest that the borrower will be faced with once the period terminates on fixed-interest rates. This can take the form of an incremental adjustment, with interest limits for intervals that start with the first-rate change after the fixed period expires.
The initial adjustment cap limits the change in interest for the first time rates are adjusted, and there are subsequent, or periodic, interest caps to cover upcoming changes in the interest rate. The life cap essentially informs the borrower how much of an increase in interest they can expect to pay at most.
Lenders should specify in their loan agreements what the life caps are on the mortgages they offer. In many instances, the life cap is shown as either a change in overall percentage or as an absolute percentage.
The life cap on a loan is used frequently as part of an interest rate cap structure. For example, a fixed period or hybrid ARM frequently has initial, periodic, and life caps. On a 5-1 hybrid ARM, this might be expressed as a 5-2-5 cap structure, meaning there is a 5% initial cap, 2% periodic cap and 5% life cap. This means that at the first interest rate change date, the rate could change by a maximum of 5%, and at each subsequent change date, the rate could change by a maximum of 2%. The maximum lifetime change in this example is 5%.
It is possible for interest rates to decrease on an ARM once the fixed-interest period has expired. Life caps would not preclude the borrower from benefiting from such interest rate changes.
The presence of a life cap does not reduce or eliminate other types of costs, such as late fees that can be part of the annual percentage rate calculation, which includes the interest rate.