What is a Periodic Interest Rate Cap
Periodic interest rate cap refers to the maximum interest rate adjustment allowed during a particular period of an adjustable rate loan or mortgage. The periodic rate cap protects the borrower by limiting how much an adjustable-rate mortgage (ARM) product may change or adjust during any single interval.
BREAKING DOWN Periodic Interest Rate Cap
When an adjustment period expires, the interest rate is adjusted to reflect prevailing rates which may be an upward or downward adjustment and is limited by the periodic interest rate cap. While the periodic interest rate cap is a crucial number to understand, it is only one of the figures which determine the structure on an adjustable-rate mortgage (ARM). Other significant terms for the borrower to know include:
- The lifetime cap is the maximum upper limit interest rate allowable on an ARM.
- 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.
- 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 usually an absolute percentage value. For example, the contractual terms of the mortgage may state that the maximum interest rate may never exceed 15%.
How do ARM Interest Rate Caps Work
Adjustable-rate mortgages come in many different types. ARMs will have descriptions which include numeric expressions of timeframes and the amount of rate increases. For example, a 3/1 ARM with an initial rate of four-percent may have a cap structure of 2/1/8.
At the end of the initial three-year period, the four percent rate may adjust as much as two percent. The adjustment may be to a lower or a higher interest rate. So, after the three-year initial period, the interest charged may change to somewhere between 2- and 6-percent. Each year after the initial adjustment, the rate can move up or down as much as one percent. At no point is the lender able to change the interest rate above eight percent.
When each adjustment is due, the lender uses one or a combination of indices to reflect current market interest rates. The lender’s choice of an index must show in the initial loan agreement. Commonly used benchmarks include the London Interbank Offered Rate (LIBOR), the 12-month Treasury Average Index, or the Constant Maturity Treasury. The lender will also add a margin to the stated interest rate. Details on the amount of the margin must also be in the original loan documentation.
While lenders cannot move the rate above that cap limit, in some cases borrowers are still responsible for rates above a cap. This situation can happen if the index plus margin would place a periodic rate above the cap. Returning to the previous example, if the lender has a 2% margin, the borrower can have an interest rate at ten percent.