A cap, also known as an interest rate cap, helps protect consumers by limiting how much the rate on variable interest loans can change. For example, a loan might have multiple caps that apply at different times during the life of the loan, such as during an initial adjustment interval or for the entire life of the loan. Caps help consumers have a better idea of what to expect when their variable interest rate changes.
We’ll take a closer look at why caps on loan interest rates exist, how they work, and the different types of caps below.
Definition and Examples of a Cap
Interest rate caps limit how much a variable interest rate can change over a set period of time. A variable interest rate, also known as a floating interest rate, can change during the life of a loan—unlike a fixed interest rate, which remains consistent month after month. Since an increase in a loan’s interest rate will likewise increase the payment due, a cap can prevent an unaffordable increase in the payment.
What does a cap look like in action? Let’s say a loan’s per-period cap is 2%, the borrower’s current rate is 5%, and the loan adjusts annually. This means that the newly adjusted rate is not allowed to rise more than 2% above the current rate, or higher than 7%. Without a cap, the interest rate could jump much higher, which could lead to payments that are more than the consumer can afford to pay.
- Alternate name: interest rate cap
How Caps Work
Caps are used in a range of financial products to limit consumers’ exposure to runaway interest rates. A couple of common examples follow below.
Credit cards are an everyday product that typically incorporate rate caps. For example, a credit card may charge a variable interest rate that is guaranteed per the agreement to rise no higher than a specific percent, such as 24%. In this case, the interest rate would be capped at 24%.
There is no federal law that limits the amount a credit card issuer can charge—read your card agreement carefully to make sure you understand if the interest rate is capped and at what amount.
Some rate caps are more generous, such as that imposed by the Servicemembers Civil Relief Act. This act benefits active-duty service members by limiting interest on credit card balances incurred prior to starting their active duty to 6%.
An adjustable rate mortgage (ARM) is an example of a loan that involves caps. ARMs are a type of mortgage that have a fixed-rate period that may last from one to five or more years, depending on the specific ARM. After the fixed-rate period expires, the interest rate can increase, depending on an interest rate benchmark, such as the London Interbank Offered Rate (LIBOR).
The amount of increase will be further determined by whatever spread the lender adds to the current interest rate as well as any caps that limit the increase (such as an initial adjustment, subsequent adjustment, and lifetime adjustment cap). Because of these caps, borrowers can plan better for their loan payments, even when they change.
Borrowers can ask their lender to calculate their highest possible payment on a variable rate loan. That way they can be better prepared in the event of a worst-case payment scenario.
Types of Caps
There is no one-size-fits-all way that caps are used to limit interest rate increases. But we’ll look at caps commonly placed on ARMs to illustrate how different types of caps can work in tandem.
Initial Adjustment Cap
An initial adjustment cap dictates how much an interest rate can increase the first time it adjusts once the fixed-rate period ends. This type of cap is often 2% or 5%. So if you have an initial adjustment cap of 2%, your new rate can’t be more than 2% higher than the initial rate you paid. If you have an initial adjustment cap of 5%, your new rate can’t increase by more than 5% than the rate.
Subsequent or Periodic Adjustment Cap
A subsequent or periodic adjustment cap states how much an interest rate can increase during subsequent adjustment periods. Meaning that if your ARM adjusts annually, your rate can’t rise by more than this cap amount each year. Typically, a subsequent adjustment cap is 2%, which means you won’t receive a new rate any higher than 2% more than your previous interest rate.
Keep in mind that subsequent or periodic adjustment caps only apply to rate increases after the first interest rate adjustment.
Lifetime Adjustment Cap
A lifetime adjustment cap is what limits the interest rate increase over the life of the loan. You’ll most often see a lifetime adjustment cap at 5%. (However, this isn’t a guarantee; some lenders have a higher rate.) For example, with a 5% lifetime adjustment cap, you won’t ever have an interest rate that is 5% higher than the initial interest rate at any point throughout the life of the loan. So if you started with an interest rate of 5%, your interest rate can never be more than 10%.
Almost all ARMs are legally required to have a lifetime cap in place.
- An interest rate cap is a safeguard for consumers with adjustable interest rate loans that can ebb and flow over time.
- Caps are featured on many financial products, including credit cards and mortgages.
- There is no one specific type of cap, and the type of caps you’ll encounter can vary by lending product.
- ARMs frequently feature an initial adjustment cap, a subsequent or periodic adjustment cap, and a lifetime adjustment cap.