Interest rate caps: What are they and how do they work?

One of the advantages of an adjustable-rate mortgage (ARM) is paying a fixed introductory interest rate that’s usually lower than the rate for a fixed-rate loan. Once that rate expires, your mortgage rate will change at specific intervals according to market rates, and your monthly payment could increase.

But how much can it go up? You’ll know the answer up front because ARMs have rate caps that limit how much your mortgage rate can change.

What is an adjustable-rate mortgage?

An ARM is a home loan where the interest rate adjusts at specific intervals.

It works like this: An ARM has an introductory period with a fixed interest rate. The initial mortgage rate on an ARM is usually lower than that of a fixed-rate mortgage. Once that rate expires, the interest rate adjusts at specific intervals based on general market conditions, including the benchmark index rate and the lender’s margin.

For example, a 5/1 ARM loan would have a fixed rate for 5 years and then adjust once a year.

With a fixed-rate mortgage, the interest rate remains the same throughout the mortgage term.

How interest rate caps work

An interest rate cap for an ARM limits how much your mortgage rate can adjust.

There are three types of interest caps:

1. Initial adjustment rate cap. This determines how much the interest rate can increase the first time it adjusts after the introductory rate expires. It’s typically between 2% and 5%.

2. Subsequent adjustment rate cap. A subsequent rate cap is how much the rate can change in each subsequent adjustment. This cap is usually 1% - 2%.

3. Lifetime adjustment cap. This is the maximum amount your rate can change from your initial rate. This cap usually is set at 5%.

When applying for an ARM, your lender will list your rate caps in the Loan Estimate and Closing Disclosure.

Interest rate floors

The interest rate floor on an ARM is the lowest interest rate that can be charged on the loan.

For example, let’s say an ARM has an interest rate floor of 4%. In that case, you’ll always pay at least 4%, even if market interest rates go lower.

Interest rate cap example

Imagine taking out an ARM with a 7-year introductory fixed interest rate of 7%, after which it adjusts annually until the loan is paid off. You’ll pay that 7% rate no matter what for the first 7 years of payments.

Say the initial adjustment cap on this loan is 3%, the subsequent rate cap is 1%, the lifetime cap is 5%, and the floor is 3%. That means the highest your rate can go on the first adjustment is 10%. After that, it can only increase by 1% each time it adjusts, and it can never exceed 12% or fall below 3%.

What affects interest rates?

An interest cap protects borrowers from interest rate spikes that could make their monthly mortgage payment unaffordable.

The interest rate on an ARM typically is determined by adding an index rate to the lender’s margin rate. Your lender will choose an index to base its ARM rates on, such as the constant maturity Treasury (CMT) rate or the secured overnight finance rate (SOFR). The margin is the lender’s share of the interest rate, and is how the lender makes money on your loan.

Is a mortgage with interest rate caps right for you?

An ARM has many advantages. If you plan to sell your home or refinance before your introductory fixed rate expires, you can save money compared with a fixed-rate loan.

If you plan to own your home longer than that, be prepared for your monthly payment to increase at some point. If market interest rates remain steady or decrease, you may save money on interest when compared with a fixed-rate loan.

When comparing loan offers, be sure to note the rate caps. ARMs with similar rates but different rate caps may vary significantly in cost.

Also, you can calculate your estimated monthly payment using the Rocket Mortgage® payment calculator. When you use the calculator you can estimate the maximum interest rate you may have to pay to be sure you can afford it. This is for educational purposes and the actual monthly payment on your mortgage may vary.

FAQ

Here are answers to common questions about interest rate caps.

What are the pros and cons of an interest rate cap agreement?

While rate caps protect borrowers from spikes in interest rates, the monthly payment on an ARM is less predictable than that on a fixed-rate loan. It’s possible to pay more in interest over time if rates increase. Even a 1% difference in your interest rate can have a significant effect on how much overall interest you pay for your mortgage.

What does a 2/5/5 rate cap mean?

A 2/5/5 rate cap has a 2% initial cap, a 5% subsequent cap, and a 5% lifetime adjustment cap.

How can you prepare for mortgage rate changes?

To be prepared for rate changes, carefully read your loan documents and make sure you understand how rate caps work. You also want to calculate your payment using the maximum interest rate you may pay to make sure you can afford it. To avoid interest rate adjustments, you can refinance into a fixed-rate loan before your loan is due to adjust.

The bottom line: Interest rate caps help protect you as an ARM borrower

If you’re taking out an ARM, interest rate caps limit how much your interest rate and monthly payment can change. If you’re an existing or potential borrower, to better prepare your finances, you’ll want to understand your ARM’s rate caps. Encourage existing and potential borrowers to understand their own ARM’s rate caps to better prepare their finances.

If you’re ready to explore your home buying options, apply for an ARM with Rocket Mortgage^® today.