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Annual limits are legal restrictions on interest and rate increases and contributions to benefit accounts, such as pensions. They prevent payment shock and tax evasion. Lenders cannot increase interest or fees beyond the annual limit, protecting borrowers. Annual limits also limit contributions to retirement accounts to prevent tax evasion. Lifetime limits are related, limiting the total amount paid over the life of a policy.
An annual limit is a legal limit on interest and rate increases for a given period, and also refers to limits on contributions to benefit accounts such as pension plans. Annual limits may be established by law or under the terms of a contract associated with a financial activity such as a mortgage. Such restrictions can prevent situations such as payment shock, where borrowers are affected by a sudden increase that exceeds their ability to pay, and may be at risk of loan default. In the case of contributions to retirement accounts, the annual limits limit the exploitation of said accounts, to avoid tax evasion.
Annual limits in terms of interest and rate increases can be seen with mortgages, credit cards, and similar financial accounts. Under the terms of the contract associated with the account, the lender may not increase interest or fees beyond the annual limit. This is especially important for adjustable rate mortgages, where the lender can adjust the interest rate in response to current market conditions.
Without an annual limit, the lender could increase the interest rate infinitely, which could create an unfair situation for the borrower. Annual limits, such as 5%, prevent lenders from unreasonably increasing interest. They allow some rate adjustment to benefit the lender, while providing an adjustment period for the borrower to get used to larger payments. Thus, in a mortgage with 4% interest and a cap of 5%, the borrower knows that the interest rate will not increase above 9% that year, and can plan accordingly.
In benefit programs, the annual cap limits the amount of contributions individuals can legally make to protected accounts. In these accounts, tax is not assessed on the income deposited into the account, to create an incentive to save for retirement. This could create a situation where people put very large sums into retirement accounts to avoid taxes, and annual limits prevent this problem. Individuals can add additional contributions if they wish, but these will not be subject to tax benefits.
The lifetime limit is a closely related concept. Many benefit plans, such as health insurance, limit the total amount paid over the life of the policy. Insurance companies use careful risk assessment to limit your chances of making a large payment, but paying for life can provide additional protection. Once payments reach a certain amount, the insurance company is no longer responsible and the policyholder must pay out of pocket. Some policies also have an annual cap to limit spending within a given benefit period.
Smart Asset.
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