Payment cap

Key Takeaways

• A payment cap limits how much the monthly payment on an adjustable-rate loan can rise at an adjustment, usually stated as a percentage of the prior payment.
• A payment cap does not limit the interest rate. Interest can keep accruing at the fully adjusted rate while the payment stays held down.
• When a capped payment does not cover the month's interest, the shortfall is added to the loan balance, which is negative amortization.
• An interest rate cap and a payment cap answer different questions. One limits the rate charged, the other limits the size of the payment increase.

What It Means

A payment cap limits how far the monthly payment on an adjustable-rate loan can jump at a single adjustment. It is usually written as a percentage of the previous payment, and the practical effect is a dollar ceiling on the new payment. That sounds like pure protection, and for a household budget it is. The problem is what a payment cap does not limit. It says nothing about the interest rate, so the rate can move to the Index plus the Margin while the payment stays pinned in place. When the capped payment no longer covers the interest that accrued that month, the shortfall does not disappear. It is added to the loan balance, and the borrower owes more at the end of the month than at the start even though every payment arrived on time. That is Negative Amortization, and it is the reason a payment cap and an interest rate cap are never interchangeable answers on an exam or in a preapproval conversation.

How It Works in Washington

Washington works on this through disclosure rather than by setting the caps. RCW 19.144.020(1) says 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 a loan application, and if any material term changes before closing, a new summary is due within three days of the change or at least three days before closing, whichever is earlier. RCW 19.144.020(2) lists what that summary must cover, including the interest rates of the loan, whether the loan contains a balloon payment, and whether the loan payments will adjust at the fully indexed rates. That last item is where a payment cap shows itself, because a capped payment is by definition a payment that is not adjusting to the fully indexed rate.

The federal layer sits underneath. Regulation Z at 12 CFR 1026.19(b)(2)(vii) requires the loan program disclosure to explain any rules relating to changes in the index, interest rate, payment amount, and outstanding loan balance, and it names interest rate or payment limitations and negative amortization as the examples. Read the Adjustment terms with a client rather than around them, because the rate environment decides whether a cap is a cushion or a trap.

Example

Dana Whitfield buys in Vancouver with a $400,000 adjustable-rate loan, thirty-year term, 4 percent start rate. Her first-year principal and interest payment is about $1,910. The note carries a 7.5 percent payment cap at each adjustment. At the first adjustment her balance is about $393,000 and the index plus margin puts her new rate at 7 percent.

Interest alone on $393,000 at 7 percent is about $2,293 a month. The payment cap holds her new payment to $1,910 times 1.075, or about $2,053. She pays $2,053, the lender books $2,293 of interest, and the $240 difference is added to her principal. Twelve months of that adds roughly $2,900 to a balance she believes she is paying down. A borrower who had an interest rate cap instead would have seen a larger payment and a shrinking balance. Dana sees a comfortable payment and a growing one. Both were protected, from different things, which is what a client comparing loan types needs to hear out loud.

Common Mistakes and Exam Traps

• A payment cap is not an interest rate cap. The rate can rise well past what the capped payment covers.
• A capped payment can still leave a borrower deeper in debt, because unpaid interest is added to principal and the balance grows.
• Payment caps are usually written as a percentage of the previous payment, while interest rate caps are written in percentage points of rate.
• Initial adjustment, subsequent adjustment, and lifetime caps all limit the interest rate, not the payment. Calling a lifetime cap a payment cap is the classic miss.