What is a Lifetime Cap
A lifetime cap is the maximum upper limit interest rate allowable on an adjustable-rate mortgage (ARM). The cap applies to the life of the mortgage. A lifetime cap, or life cap, tells a borrower the maximum interest rate they could pay during the life of the loan.
Lifetime caps limit the risks of substantial interest rate increases over the life of the mortgage. Initial and periodic caps limit the amount by which an ARM's interest rate can increase at any single interest rate adjustment date.
BREAKING DOWN Lifetime Cap
The formulation of a lifetime cap's value is as the percentage increase from an initial interest rate. For example, if a fixed period ARM has an initial fixed interest rate of 5-percent and a lifetime cap of 5-percent, the maximum interest rate allowed is 10-percent. Lifetime caps are part of an ARM's mortgage's interest rate cap structure and may take several forms. Lenders have the flexibility to customize interest rate limit, initial, periodic, and life caps.
While lifetime cap is a crucial number to understand, it is only one of the figures which determine the structure on an adjustable-rate mortgage. Other significant terms for the borrower to know include:
- An initial interest rate is an introductory rate on an adjustable or floating rate loan, typically below the prevailing interest rates which remains constant for a period of six months to 10 years.
- The initial adjustment rate cap is the maximum amount the rate may move on the first scheduled adjustment date.
- A periodic adjustment rate is a maximum adjustment allowed during one adjustment interval of an adjustable rate loan.
- The rate floor is the agreed upon rate in the lower range of rates associated with a floating rate loan product.
- An interest rate ceiling which is similar to and sometimes referred to as, lifetime caps. However, an interest rate ceiling is usually expressed as an absolute percentage value. For example, the contractual terms of the mortgage may state that the maximum interest rate may never exceed 15%.
The terms of an ARM are all indicated in the description of the ARM. For example, a 5/1 ARM requires fixed rate interest for five years followed by variable rate interest which resets every 12 months. In this mortgage product, borrowers can often choose between a 2-2-6 or a 5-2-5 interest rate cap structure. In these quotes the first number refers to the first increase cap, the second number is a periodic 12-month incremental increase cap, and the third number is a lifetime cap setting the maximum interest rate ceiling.
Understanding these terms and concepts means that the borrower can calculate the dollar amount of the monthly payment if the ARM hits the lifetime cap.
Using Lifetime Cap To Make Decisions
Because an adjustable-rate mortgage follows a set formula, borrowers can understand the implications of different lengths of time for the initial rate and periodic adjustments, as well as the impact of varying rate changes and caps. Understanding the lifetime cap helps a buyer know the maximum monthly payment amount which could be required. Knowing this monthly payment amount may help them to determine whether this type of mortgage suits them. If the lifetime cap puts the monthly payments out of reach of the borrower, this particular mortgage is not the right loan for that buyer to take.
Understanding the lifetime cap informs the strategy the borrower uses to fund a real estate purchase. Since starting interest rates for ARMs are generally lower than rates for fixed-rate mortgages (FRMs), inducing borrowers to choose the ARM. If the lifetime cap on an ARM is higher than the borrower wants to pay monthly, the borrower may decide to refinance the mortgage before the initial rate increase period is due. In this way, they can get the lower initial rate but switch to a new mortgage before the higher rates apply.