An annual cap is a provision clause contained in a adjustable rate mortgage (ARM)loan contract which limits the potential increase of interest rates within the year.

This rate increase limit is often stated in the loan agreement in terms of percentage points.

For example, a cap of 1% on an ARM currently at 3% would mean that the maximum interest rate would be 3% + 1% which equates to 4%. This applies even when the current market rate for new home loans is 6%.

This helps serves as an assurance to borrowers that sudden interest rate hikes in the economy would have a limited impact on their interest charges and monthly payments.

The annual mortgage cap can sometimes also be expressed as a dollar amount with regards to the monthly payment amount which consists of principal and interest.

This means that even if interest rates rise exponentially, resulting in a calculated mortgage payment of $1,000, an annual cap of $789 specified in the loan contract would mean that the borrower would only be obligated to make payment of $789 to keep in line with the terms of the agreement without being in breach.

However, even though this might seem like a win for borrowers, keep in mind that the deficit that was not paid does not vanish into thin air, but makes it’s way to the principal balance.

This can also lead to negative amortization issues.

When signing up for an ARM, do take notice of whether this clause is present in the contract. And if it isn’t consider requesting for one as it can act as a safeguard against unpredictable times.