What Is a Lifetime Cap?
The term lifetime cap refers to the maximum interest rate allowable on an adjustable-rate mortgage (ARM). This cap applies to the entire duration of the mortgage.
Lifetime caps limit the risks associated with the substantial interest rate increases over the life of the mortgage for the borrower, but can generate interest risk for the lender if rates rise sufficiently.
- A lifetime cap is the maximum interest rate a borrower could ever pay during the life of a loan.
- If interest rates exceed the lifetime cap, the borrower will still be limited to paying this maximum rate.
- Lenders can customize interest rate limits along with the initial, periodic, and life caps.
- Understanding how caps work can help borrowers determine their monthly payments if the ARM hits the lifetime maximum.
How Lifetime Caps Work
There are many different types of mortgage products available on the market. Borrowers have the option of fixed-rate products, where the interest rate is constant throughout the term of the loan. Since the rate is constant, people with fixed-rate mortgages are able to predict the costs associated with their mortgages. Interest rates for adjustable-rate (variable) mortgages, on the other hand, vary throughout the life of the loan. It is constant for the initial period, after which it adjusts at regular intervals until the loan is paid off.
The terms of an ARM are all indicated in the description of the product itself. For example, a 5/1 ARM requires a fixed rate of interest for five years followed by a variable interest rate that resets every 12 months. 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.
Initial and periodic caps limit the amount by which the mortgage's interest rate can increase at any single interest rate adjustment date. The lifetime cap, though, is the maximum interest rate that a borrower must pay throughout the entire term. The formulation of a lifetime cap's value mirrors the percentage increase from an initial interest rate. For example, if a fixed-period ARM has an initial fixed interest rate of 5% and a lifetime cap of 5%, the maximum interest rate allowed is 10%.
Lifetime caps are part of an ARM's interest rate cap structure and may take several forms. Lenders have the flexibility to customize interest rate limits along with the initial, periodic, and life caps.
Understanding how caps work can help borrowers determine their monthly payments if the ARM hits the lifetime maximum. While the lifetime cap is important to understand, it is only one of the figures which determine the structure of an adjustable-rate mortgage. Other significant terms for the borrower to know include:
- An initial interest rate, which 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 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%.
There are figures other than the lifetime cap that factor into an adjustable-rate mortgage that can help you determine whether this is the right product for you.
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 they may be required to pay. Knowing this monthly payment amount may help them 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. Starting interest rates for ARMs are generally lower than rates for fixed-rate mortgages, 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.