What Is an Annual ARM Cap?

An annual ARM cap is a clause in the contract of an adjustable-rate mortgage (ARM), limiting the possible increase in the loan's interest rate during each year. The cap, or limit, is usually defined in terms of rate, but the dollar amount of the principal and interest payment may be capped as well.

Annual caps are designed to protect borrowers against a sudden and excessive increase in their monthly payments when rates rise sharply over a short period of time.

KEY TAKEAWAYS

  • An annual ARM cap is an interest rate limit, denoting the highest possible rate a borrower may have to pay on an adjustable-rate mortgage (ARM) in a given year.
  • Most often, the interest rate will be capped on an ARM, but certain ARMs may instead cap the monthly or annual dollar amount paid.
  • In addition to annual caps that reset every 12 months, there may also be a lifetime interest rate cap on the loan.

Understanding Annual ARM Caps

With an ARM, the initial interest rate is fixed for a period of time—five years, for example, in the case of a 5/1 ARM—after which it resets periodically based on current interest rates every year (i.e., the "1" in the 5/1). ARMs also typically have lifetime rate caps that set limits on how much the interest can increase over the life of the loan.

ARMs with a capped interest rate have a variable rate structure, which includes an indexed rate and a spread above that index. There are several popular indexes used for different types of ARMs such as the prime rate or the federal funds rate. The interest rate on an ARM with its index is an example of a fully indexed interest rate. An indexed rate is based on the lowest rate creditors are willing to offer. The spread or margin is based on a borrower’s credit profile and determined by the underwriter.

The annual interest rate of an ARM loan with an annual cap will only increase as much as the terms allow in percentage points, regardless of how much rates may actually rise during the initial period. For example, a 5% ARM that is fixed for three years with a 2% cap can only adjust to 7% in the fourth year, even if rates increase by 4% over the initial fixed term of the loan. A loan with a dollar cap can only increase by so much as well, although this type of cap can lead to negative amortization in some cases.1

The ARM's interest rate cap structure outlines the provisions governing interest rate increases over the term of the loan.

ARM Payment Cap Example

ARMs have many variations of interest rate cap structures. For example, let's say a borrower is considering a 5/1 ARM, which requires a fixed interest rate for five years followed by a variable interest rate afterward, which resets every 12 months.

With this mortgage product, the borrower is offered a 2-2-5 interest rate cap structure. The interest rate cap structure is broken down as follows:

  • The first number refers to the initial incremental increase cap after the fixed-rate period expires. In other words, 2% is the maximum the rate can increase after the fixed-rate period ends in five years. So, if the fixed-rate was set at 3.5%, the cap on the rate would be 5.5% after the end of the five-year period.
  • The second number is a periodic 12-month incremental increase cap, meaning that after the five-year period has expired the rate will adjust to current market rates once per year. In this example, the ARM would have a 2% limit for that adjustment. It's quite common that the periodic cap is identical to the initial cap.
  • The third number is the lifetime cap, setting the maximum interest rate ceiling. In this example, the five represents the maximum interest rate increases on the mortgage.

So, let's say the fixed rate was 3.5% and the rate was adjusted higher by 2% during the initial incremental increase to a rate of 5.5%. After 12 months, mortgage rates rose to 8%; the loan rate would be adjusted to 7.5% because of the 2% cap for the annual adjustment. If rates then increased by another 2%, the loan would only increase by 1% to 8.5%, because the lifetime cap is five percentage points above the original fixed rate.

The Ups and Downs of an ARM

ARMs often allow borrowers to qualify for larger initial mortgage loans because they lock in a lower payment for a period of time. Users of an ARM can benefit when interest rates decrease, lowering the annual interest rate paid. At the same time, of course, during a period of rising rates, ARMs can increase well beyond what a fixed-rate mortgage would have been.

For instance, if a buyer takes out an ARM at 3.5% at three years fixed and rates increase 4% during that period, this initial annual rate increase will be limited to the annual cap. However, in subsequent years, the rate may continue to increase, eventually catching up with current rates, which may continue to climb.

Eventually, a 3.5% ARM, which initially was competitive with a 4.25% fixed rate, could end up being significantly higher. ARM borrowers often look to switch to a fixed-rate when rates are rising, but may still end up paying more having used the ARM.