Lifetime Cap: What It Means, How It Works

What Is a Lifetime Cap?

A lifetime cap is the maximum interest rate allowable on an adjustable-rate mortgage (ARM). This cap applies to the entire duration of the mortgage. Lifetime caps limit the risks associated with the substantial interest rate increases over the life of the mortgage for the borrower, but can generate interest risk for the lender if rates rise sufficiently.

How Lifetime Caps Work

There are many different types of mortgage products available on the market. Borrowers have the option of fixed-rate products, where the interest rate is constant throughout the term of the loan. Since the rate is constant, people with fixed-rate mortgages can better predict the costs associated with their mortgages.

Interest rates for adjustable-rate (variable) mortgages, on the other hand, vary throughout the life of the loan. It is constant for the initial period, after which it adjusts at regular intervals until the loan is paid off.

The terms of an ARM are all indicated in the description of the product itself. For example, a 5/1 ARM requires a fixed rate of interest for five years followed by a variable interest rate that resets every 12 months.

Borrowers can often choose between a 2-2-6 or a 5-2-5 interest rate cap structure. In these quotes, the first number refers to the first increase cap, the second number is a periodic 12-month incremental increase cap, and the third number is a lifetime cap.

Initial and periodic caps limit the amount by which the mortgage's interest rate can increase at any single interest rate adjustment date. The lifetime cap, though, is the maximum interest rate that you must pay throughout the entire term. The formulation of a lifetime cap's value mirrors the percentage increase from an initial interest rate. For example, if a fixed-period ARM has an initial fixed interest rate of 5% and a lifetime cap of 5%, the maximum interest rate allowed is 10%.

Other Interest Rate Terms

Understanding how caps work can help you determine your monthly payments if the ARM hits the lifetime maximum. While the lifetime cap is important to understand, it is only one of the figures which determine the structure of an adjustable-rate mortgage.

Other significant terms related to interest rates include:

• An initial interest rate, which is an introductory rate on an adjustable or floating rate loan, typically below the prevailing interest rates, which remains constant for a period of six months to 10 years. 
• The initial adjustment rate cap is the maximum amount the rate may move on the first scheduled adjustment date. 
• A periodic adjustment rate is a maximum adjustment allowed during one adjustment interval of an adjustable-rate loan.
• The rate floor is the agreed-upon rate in the lower range of rates associated with a floating rate loan product.
• An interest rate ceiling is similar to and sometimes referred to as lifetime caps. However, an interest rate ceiling is usually expressed as an absolute percentage value. For example, the contractual terms of the mortgage may state that the maximum interest rate may never exceed 15%.

Understanding the lifetime cap helps you know the maximum monthly payment amount you may be required to pay. Knowing this monthly payment amount may help you determine whether this type of mortgage suits you. If the lifetime cap puts the monthly payments out of reach, this mortgage may not be right for you.

The lifetime cap informs the strategy you use to fund a real estate purchase. Starting interest rates for ARMs are generally lower than rates for fixed-rate mortgages, inducing borrowers to choose the ARM.

If the lifetime cap on an ARM is higher than you want to pay monthly, you may decide to refinance the mortgage before the initial rate increase period is due. In this way, they can get the lower initial rate but switch to a new mortgage before the higher rates apply. You can ask the lender to calculate the maximum payment you will ever have to pay.

Frequently Asked Questions (FAQs)

Bottom Line

The lifetime cap on an adjustable rate mortgage is important information because it can help you calculate the maximum you may pay for a mortgage. This way, you can choose the mortgage that best suits your needs. Weigh the pros and cons, including the total costs, of several mortgages before you decide to accept one.