Definition
Rate caps (ARM caps)
Rate caps are limits on how much an adjustable-rate mortgage's interest rate can change. Most ARMs have three: an initial adjustment cap, a periodic cap for each later adjustment and a lifetime cap over the life of the loan. Caps are written into the loan documents and are often shown as three numbers, such as 2/1/5.
Cap notation lists the initial, periodic and lifetime caps in that order. In a 5/2/5 structure, the rate can move up to 5 percentage points at the first adjustment, 2 points at each later adjustment, and never more than 5 points above the start rate.
Worked example. An ARM starts at 6% with 2/1/5 caps. At the first adjustment, even if the index plus margin works out to 9%, the rate can rise only to 8%. At the next adjustment it can rise at most to 9%, and over the life of the loan it can never exceed 11%. Calculating the payment at that 11% ceiling gives the borrower a worst case to plan around.
Caps usually work in both directions, limiting decreases as well, and many ARMs also have a floor. Some older or non-QM products use payment caps instead of rate caps, which can lead to negative amortization when the capped payment does not cover interest. Caps vary by lender and product, so the numbers on the Loan Estimate and note are the ones that matter. The APR calculator for ARMs assumes a single adjusted rate, so pick one the caps would actually allow.
Calculators that use this term
FAQ · 2 questions
Questions about Rate caps (ARM caps)
What does a 2/2/5 cap mean?
The rate can change by up to 2 points at the first adjustment, up to 2 points at each later adjustment, and up to 5 points above the starting rate over the life of the loan.
Do rate caps also limit how far my rate can fall?
Often yes, the same caps apply to decreases. Many ARMs also set a floor, frequently equal to the margin, below which the rate cannot drop.
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