What is an interest rate cap structure?
If you’re considering home financing options, you might be hesitant about changing interest rates associated with adjustable rate mortgages. While it’s true that the amount you pay will eventually be tied to market forces beyond your control, there are limits in place to protect your loan and prevent your mortgage bill from radically changing.
What is an interest rate cap structure?
Interest rate caps are of significant importance if you decide to take out an adjustable rate mortgage. Adjustable rate mortgages, or ARMs, feature a fixed interest rate for a number of years, before being periodically adjusted when the fixed rate term concludes.
For example, a 7/1 ARM would set you up with a fixed interest rate for seven years, before being adjusted annually when those first seven years are up. Depending on the lender you choose to work with, the fixed rate period on an ARM can range from 1-10 years. When your rate is adjusted according to the real estate index and margins, your monthly mortgage payments may go up or down as a result.
A fixed-rate period of 1-10 years is more than enough time for the economy to fluctuate widely. Homeowners can't predict or influence how the market will evolve, so ARMs might be perceived as a slightly riskier lending option. Much of this concern is mitigated, however, by putting a ceiling on how much your rate can increase.
The interest rate cap structure was put in place to protect both borrowers and lenders from financing arrangements that come with infinite risk. Without establishing these limits, a sudden change in the real estate market, such as falling home values and spiking average interest rates, could saddle you with an insurmountable amount of interest attached to your loan.
On the other hand, if the economy turns against your lender, they’ll have much more difficulty turning a profit on the mortgages they’ve issued with plummeting interest rates attached. The interest rate cap therefore includes a floor on the mortgage’s rate, protecting your lender from sharply decreasing interest payments that could hurt their bottom line.
Fixed rate mortgages, on the other hand, won’t include rate adjustment caps because the interest on those loans don’t budge.
Initial interest rate cap
One of the benefits of adjustable rate mortgages is that the interest rate for the first few years of the loan is generally lower than other fixed rate mortgage options. In the past, the lure of a lower initial interest rate has drawn in borrowers looking to save on their monthly mortgage bills, only to be in for an unfortunate surprise when the fixed rate term expires and their monthly payment is adjusted to an amount beyond what they can afford.
The initial interest rate cap protects you from being forced to pay an exorbitant amount if market forces cause interest rates to rise. This makes adjustable rate mortgages a much more palatable lending option, since borrowers won’t be completely subject to whatever the economy throws their way.
Your lender will also appreciate these limits, since it also prevents your interest rate from dropping below an amount where the loan is no longer a viable business investment.
Let's say you secure a 7/1 ARM with an initial interest rate of 3% and the cap established at +-2%. When it comes time for your interest rate to be adjusted, the new amount could not exceed 5% and would be restricted from dropping below 1%.
While this cap only prevents dramatic changes during your initial rate adjustment, there are other caps in place that limit your subsequent rate changes.
Periodic interest rate caps
If you’re taking out an adjustable rate mortgage, limits are also structured as incremental caps, regulating how much your rate can increase when it periodically adjusts.
Following your first adjustment, your ARM’s rate will go through periodic adjustments that will change according to the market index and margins at predetermined intervals. On a 5/1 ARM, for example, you would encounter a rate adjustment once per year following the initial 5-year fixed rate period.
The periodic interest cap, much like the initial initial rate cap, limits how much your monthly payments can increase. However, the periodic interest rate cap protects you from rapid market changes throughout the life of the loan, rather than at the initial interest adjustment.
The periodic interest rate cap is lower than the initial cap, usually set at 1%. If your interest rate was 3% before the adjustment, it could not exceed 4% or decrease beyond 2%.
How the interest rate cap is determined
The interest rate cap is influenced by a variety of market forces and regulatory decisions. On the typical mortgage, there are three main factors driving how the rate cap is set:
- Strike rate
Simply put, the notional is the size of the actual loan being covered by the cap. Caps are defined as a percentage of the overall loan amount; as the notional increases so will the size of the mortgage’s limit.
The cap’s term lays out how long your loan will be protected from fluctuating beyond its limit, typically spanning the life of the loan. On an ARM with a 30-year amortization schedule, for example, the term of the loan would last 30 years.
The strike rate sets your interest cap in stone by establishing the percentage that your interest payments cannot exceed. If your interest rate was set at 3%, with a cap of 2%, your strike rate would be defined as 5%.
It might sound like another complicated finance term, but interest rate caps play a vital role in protecting your mortgage payments and sustaining the viability of the mortgage process.
Not only do they allow ARMs to be more secure for you as the borrower, but they also provide important protections for your lender and make financing options more accessible to homeowners overall.
Disclaimer: Sample loan scenarios are provided for illustration purposes only and are not intended to provide mortgage or other financial advice specific to the circumstances of any individual and should not be relied upon in that regard. For representative examples go to rate.com/marketing disclaimers. For more information about Adjustable Rate Mortgages, visit ConsumerFinance.gov.