For home loans on adjustable interest rates, there are usually mechanisms in place to prevent borrowers and lenders from becoming victims of volatile rate movements in the market.
While most people feel that limit on how high rates can spike on their loan protect them, there are also limits to how low rates can fall to protect lenders.
Here are some of the common mechanisms in place to limit the movement of mortgage rates.
Interest rate ceiling
Sometimes known as the lifetime cap, the interest rate ceiling sets an upper limit of how high interest rate on the loan can be.
This states the maximum amount and any further spikes in index rates beyond this point will still result in the maximum rate specified here being used.
It is usually expressed as percentage points plus the index that is used.
This means that if the ceiling is 7%, and index of 6% plus a margin of 3% would result in a fully indexed rate of 9%. But the ceiling would keep the mortgage rate at 7% since that is the maximum allowed.
This also implies that if the index rate alone is above the interest rate ceiling, the ceiling would still prevails. Leaving no room to even add the margin.
Rate adjustment cap
The rate adjustment cap specifies the maximum amount any single adjustment can be.
For example, if the adjustment cap is 1% and the index rate increased by 2%, after the adjustment interval, the maximum increase in the home loan’s interest is still 1%.
This applies for both increase and decrease of rates.
It protects borrowers from sudden rate increases and lenders from sudden rate decreases.
The presence of rate adjustment caps don’t mean that interest don’t rise much. It just means that it takes a longer time for rates to rise considerably. Thus, helping borrowers buffer such financial impacts.
For example if interest rise from 2% to 5% from some freak economic accident and the rate adjustment cap is 1%, it would take 3 adjustment intervals of 1% each for the rate to increase from 2% to 5%.
In this case, the rate might even fall back to 3% by the time it reaches the third interval.
So such a mechanism helps protect borrowers from surges in interest costs.
Interest rate decrease cap
Somewhat similar to the rate adjustment cap, the interest rate decrease cap dictate the maximum amount of decrease allowed on any single adjustment.
Sometimes this mechanism can appear alone in a mortgage contract. Sometimes, it can be present together with a rate adjustment cap.
This enables a lender to quietly disguise the small adjustments should interest rates go down.
Interest rate increase cap
The opposite of a decrease cap, an increase cap puts a limit on how much an increase can be.
Like the interest rates decrease cap, this can enable a lender to set adjustment limits but a higher limit for increases.
Interest rate floor
This states the minimum amount, or lower limit, of percentage interest on the loan.
This feature is to protect lenders from strange rate movements.
For example, LIBOR were in negative territory for much of the last decade. If borrowers are literally charged negative rates on their mortgages, lenders would have to pay borrowers to main these loans.
That sounds ludicrous.
The interest rate floor ensures that there is a minimum interest that borrower will pay no matter how low general interest rates in the economy are moving.
Payment adjustment cap
This mortgage feature can be a critical element for borrowers who have cash flow problems.