A lifetime cap is the maximum interest rate a lender can charge on an adjustable-rate mortgage (ARM) over the life of the loan, protecting borrowers from volatile benchmarks. ARMs offer variable interest rates linked to a benchmark, while fixed-rate mortgages offer a single interest rate for the life of the loan.
A lifetime cap is the maximum guaranteed interest rate a lender can charge on an adjustable-rate mortgage (ARM) over the life of the loan. The interest rate on an ARM fluctuates based on a benchmark. Sometimes the interest rate fluctuates as frequently as every month. To assure borrowers that the interest rate on their loans will never exceed a certain rate, the lender sets a limit that is equal to the fixed rate of the loan plus a certain maximum percentage.
Lenders design different loan products in the residential real estate market to meet the needs of borrowers. Two of the main types of mortgage products are lump sum mortgages and ARMs. Fixed-rate mortgages offer the borrower a single interest rate that remains in effect for the life of the loan, which can be as long as 15 or 30 years. This type of loan provides the borrower with certainty regarding their periodic loan payments, but it can also be an albatross if lower interest rate mortgages become available in later years.
To protect the borrower against the possibility that interest rates may decrease, they may choose to take out an ARM instead. An ARM uses a variable interest rate that is linked to a benchmark that will rise and fall with economic conditions in the country where the loan is made. The terms of the loan designate a popular ARM benchmark and a fixed percentage to be added to the benchmark percentage to establish the actual interest rate on the ARM at any time. In practice, the benchmark might fluctuate between two and three percent, for example, while the fixed rate on the ARM might be set at four percent. This scenario would result in a fluctuating interest rate on the loan between six and seven percent.
The way the lender offers to protect the borrower against a volatile benchmark is by setting a lifetime limit. This limit works as a hard maximum interest rate that can be charged for the loan. The lifetime limit is added to the ARM rate to determine the maximum rate. If the ARM rate is four percent and the lifetime limit is five percent, the interest charged on the loan cannot exceed nine percent, no matter how high the benchmark. As a practical example, if the benchmark were to increase to 6% for an ARM with an interest rate of 4% and a lifetime limit of 5%, the maximum interest rate the lender could charge the borrower would be 9%. , although the benchmark actually raises the floating interest rate to 10%.
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