An interest rate ceiling is the maximum interest a lender can charge a borrower on a loan regardless of the market index. It prevents banks and other lenders from overcharging interest and protects consumers from predatory lending practices.
Interest rate ceilings are specific to each loan contract or investment, and are commonly used variable-rate loans such as adjustable-rate mortgages (ARM). Understanding the ins and outs of interest rate ceilings can help you decide if a loan or investment with an interest rate cap is right for you.
Definition and Examples of an Interest Rate Ceiling
An interest rate ceiling limits the amount of interest a lender can increase. It is defined within the loan contract terms and prevents rates from rising above a specified amount.
Interest rate ceilings aim to protect consumers and prohibit abusive lending practices. The concept of interest rate ceilings stems from ancient usury laws, which were made to protect consumers from extremely high interest rates.
Except for regulations for federal credit unions, there are no federal interest rate cap laws. Instead, each state has its own set of usury laws that set the legal maximum interest rate a lender can charge. As a result, the limits vary by state, and the maximum amount of interest you can be charged may depend on where the lender is located, not the state in which you live.
The lowest amount a bank will charge on a loan, an interest rate floor, is the opposite of an interest rate ceiling.
- Alternate name: Interest rate cap or rate cap
One common financial product where interest rate ceilings play a crucial role are adjustable-rate mortgages. These mortgages can provide more competitive interest rates, but they may change with the broader interest rate market. They may be ideal for buyers who want to take advantage of lower current rates; however, with an adjustable rate feature, buyers would also be subject to higher interest rates in the future.
Interest rate ceilings give borrowers protection from rates rising too sharply. While the interest rate of an adjustable-rate mortgage may rise, it will never go beyond the amount specified in the contract.
Interest rate ceilings play a similar role in other loan products with adjustable rates.
How Does an Interest Rate Ceiling Work?
By capping interest rate increases, interest rate ceilings help protect consumers from facing a significant and sudden increase in the amount of interest they pay. That can help keep their monthly costs from skyrocketing, as well as keep their total interest cost under a certain amount.
Lenders can also benefit from an interest rate ceiling because while they may not get to charge significantly more in interest, a cap reduces the likelihood a borrower will default.
Most borrowers will encounter an interest rate ceiling when securing an ARM. Like the name implies, an adjustable-rate mortgage adjusts interest rates several times throughout the life of the loan. The timing and limits of these adjustments depend on the terms negotiated in the mortgage contract.
Each of these adjustments has a specific interest rate ceiling:
- Initial adjustment cap: The maximum amount the interest rate can adjust the first time it adjusts.
- Subsequent adjustment cap (periodic adjustment): The maximum interest rate per single adjustment after the initial cap, usually no more or less than 2%, meaning it does not increase or decrease more than 2% from the previous rate.
- Lifetime adjustment cap: The total limit that the interest rate can increase from the fixed rate over the life of the loan. A common lifetime adjustment cap is 5%.
You’ll often see interest rate ceilings for ARMS written in a numeric structure like 5/2/5, where the first number is the initial cap, the second is the periodic cap, and the third is the lifetime cap.
In a 5/2/5 ARM with a base rate of 6%, the loan rates would be as follows:
- The initial adjustment cannot be more or less than 5% of the base rate (6%), which means it could not go below 1% nor above 11%.
- The periodic adjustment cannot be more or less than 2%, so the second adjustment and all the ones after could not be higher than 8% nor lower than 4%.
- Despite what the market dictates, the interest rate cannot be more or less than 5% of your base interest rate for the loan duration. So the interest would never go below 1% nor above 11%.
If the lender is a federal credit union, the interest rate is regulated by The Federal Credit Union Act of 1934. This law established a 12% interest rate ceiling for all loans given by federal credit unions; however, it gives the National Credit Union Administration (NCUA) the authority to raise the interest rate ceiling for 18-month periods. Currently, NCUA has set the interest rate ceiling for loans from federal credit unions at 18% through March 2023.
Pros and Cons of an Interest Rate Ceiling
Interest rate ceilings generally help borrowers avoid difficult financial situations that can result from quickly increased interest rates; however, several factors play roles in whether a loan’s interest rate ceiling is right for you.
Your current financial situation and how long you plan on living in your home are the main factors when considering an ARM or variable-rate loan with an interest rate ceiling, Steven M. Herman, partner at Cadwalader, Wickersham & Taft, told The Balance in a phone interview.
“Some people want to get the lowest rate they can so, for example, they start off with 1% [interest rate] on an adjustable-rate mortgage,” he said. Other buyers may not plan on living in their homes for long periods of time, so they may benefit from the lower initial interest rates ARMs can offer.
For any adjustable-rate loan product, factor in your personal financial situation as well as how long you will need the loan as you consider its interest rate ceilings.
Loans with interest rate ceilings and adjustable rates have pros and cons for different types of borrowers. Here are a few to consider:
Limits interest rate increases
Protects borrowers from broader interest rate fluctuations
May offer lower initial interest rates
Prevents predatory lending practices
Helps reduce risk of default
Could cost more in interest
Monthly payment amounts could change
- Limits interest rate increases: You don’t have to worry about paying a higher interest rate than the cap specified in your loan contract.
- Protects borrowers from broader interest rate fluctuations: The amount of interest you pay won’t exceed your caps regardless of how high benchmark interest rates rise.
- May offer lower interest rates: Short-term borrowers can often take advantage of lower initial interest rates. For example, a mortgage loan with interest rate ceilings may be suitable for borrowers who aren’t tied to their home long term. With an ARM, they could pay a lower introductory interest rate and sell the home before an interest adjustment occurs.
- Prevents predatory lending practices: Thanks to usury laws, interest rate ceilings prevent lenders from overcharging interest on loans.
- Helps reduce risk of default: Interest rate ceilings can help keep interest rates low in rising markets so borrowers can better afford payments.
- Could cost more in interest: When interest rates are rising, a loan product with adjustable rates could cost more in interest over the long term compared to a loan with a fixed rate.
- Monthly payment amounts could change: Since loan products with adjustable interest rates allow for market fluctuations, the amount a borrower owes each month could change regularly depending on the loan terms and caps.
- An interest rate ceiling is the maximum interest rate a lender can charge a borrower on a loan.
- Consumers commonly encounter interest rate ceilings on adjustable-rate mortgages and variable-rate loans.
- Each state regulates and sets its own interest rate caps for most loan products.
- Interest rate ceilings can help protect borrowers from abusive lending practices.