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 interest rate of the loan during each year. The cap, or limit, is usually set in terms of rates, but the dollar amount of principal and interest payment can also be capped.

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.

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 periodically resets to 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 interest increases over the life of the loan.

Interest rate capped ARMs have a floating 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 that creditors are willing to offer. The spread or margin is based on the borrower’s credit profile and determined by the underwriter.

The annual interest rate for an ARM loan with an annual cap will only increase as much as terms allow in percentage points, regardless of the actual rate increase during the initial period. For example, a 5% ARM 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 to a certain extent, although this type of cap can result in negative amortization in some cases.

Example of ARM payment cap

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

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

• The first number refers to the initial cap for gradual increase 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. Thus, if the fixed rate were set at 3.5%, the rate cap would be 5.5% after the end of the five-year period.
• The second digit is a 12-month periodic increase cap, which means that after the five-year period expires, the rate will adjust to current market rates once a year. In this example, the ARM would have a limit of 2% for this adjustment. It is quite common for the periodic cap to be the same as the initial cap.
• The third digit is the lifetime cap, setting the ceiling for the maximum interest rate. In this example, the fives represent the maximum increases in the interest rate on the mortgage.

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

The ups and downs of an ARM

ARMs often allow borrowers to qualify for larger initial mortgages because they lock in a lower payment for a period of time. ARM users can benefit when interest rates fall, reducing the annual interest rate paid. At the same time, of course, during a period of rising rates, ARMs can rise far beyond what a fixed rate mortgage would have been.

For example, if a buyer purchases an ARM at 3.5% over three fixed years and rates increase by 4% over that period, that initial annual rate increase will be capped at the annual cap. However, in subsequent years, the rate may continue to rise, eventually catching up to current rates, which may continue to climb.

Eventually, an ARM of 3.5%, which was initially competitive with a fixed rate of 4.25%, could end up being significantly higher. ARM borrowers often look to switch to a fixed rate when rates rise, but may still end up paying more after using the ARM.