Interest rate cap

Key Takeaways

• An interest rate cap limits how far the rate on an adjustable loan can rise, and most such loans carry three: an initial cap at the first adjustment, a periodic cap at each later one, and a lifetime cap for the whole term.
• The lifetime cap is measured from the loan's starting rate, so a 5.5 percent start with a five point lifetime cap can never exceed 10.5 percent.
• A rate cap and a payment cap do different jobs. A rate cap limits the interest rate, while a payment cap limits the monthly payment and can leave unpaid interest behind.
• Washington requires a plain language disclosure summary of the material loan terms, adjustable rate terms included, within three business days after a residential mortgage loan application (RCW 19.144.020).

What It Means

An interest rate cap is the ceiling written into an adjustable rate loan. The rate on that loan is not fixed. At each adjustment date the lender rebuilds it by taking a published Index and adding a fixed Margin. The index moves with the market, so without a limit the borrower's rate could climb as far as the market did in that period.

Caps set the limit in three places. The initial cap governs the first adjustment, which is usually the largest jump because it follows a discounted start rate. The periodic cap governs every adjustment after that. The lifetime cap is the absolute ceiling for the life of the loan, measured from the starting rate. Lenders quote the three numbers in that order, as in 2/2/5.

Caps limit the rate, not the market. If the index climbs higher than the cap allows, the borrower pays the capped rate and the lender carries the difference until the next adjustment. That protection is the tradeoff a borrower accepts in exchange for the lower opening rate an adjustable loan offers against a Fixed Rate Mortgage.

How It Works in Washington

Caps are set by the loan contract rather than by a Washington statute, so the state's role is disclosure and product limits. RCW 19.144.020 provides that a residential mortgage loan may not be made unless a disclosure summary of all material terms is placed on a separate sheet of paper and provided to the borrower within three business days following receipt of the loan application, and the department's form must cover adjustable rates along with fees, discount points, prepayment penalties, balloon payments, and escrow arrangements. If the terms change before closing, an updated summary is due within three days of the change or at least three days before closing, whichever comes first.

Washington also limits the product itself. Under RCW 19.144.050 a financial institution may not make or facilitate a residential mortgage loan that includes provisions imposing Negative Amortization and that is subject to the interagency guidance on nontraditional mortgage product risks and the statement on subprime mortgage lending, guidance that RCW 19.144.030 directs the department to apply to financial institutions. That limit matters here, because the classic route to owing more than you borrowed is a payment cap that holds the payment down while the rate keeps rising. Our guide to loan types puts adjustable products next to the rest of the menu a buyer sees.

Example

Priya finances a Renton townhouse with a $400,000 five year adjustable loan. The start rate is 5.5 percent and the caps are 2/2/5. At the first adjustment the index sits at 4.75 percent and her margin is 3.5 percent.

Index plus margin is 8.25 percent. The initial cap allows only a two point move from 5.5 percent, so her new rate is 7.5 percent instead. Her balance has amortized to roughly $369,800 with 25 years left, so the recalculated payment lands near $2,730 a month rather than the roughly $2,915 the uncapped rate would have produced. The cap is worth about $185 a month to her during that adjustment period.

Looking forward, the lifetime cap of five points sets a permanent ceiling of 10.5 percent, and the periodic cap of two points means the following adjustment cannot exceed 9.5 percent no matter where the index goes. The caps speak only to how far the rate may rise; they promise nothing about where the rate lands if the index falls. Swings like this are also what move Washington buyers in and out of the market, which our post on interest rates and Washington home sales works through.

Common Mistakes and Exam Traps

• A payment cap is not a rate cap. Holding the payment down while the rate rises can leave interest unpaid, and that unpaid interest is added to the principal balance.
• The lifetime cap runs from the loan's original start rate, not from the rate in effect at the most recent adjustment.
• Caps do not limit the index or the margin. They limit only the rate that results from adding the two together.
• The initial cap and the periodic cap are often the same number, but they are not the same rule. The initial cap applies once, at the first adjustment.