Annual Cap

Gettin' a mortgage? Great. You have two basic flavors. You can pay based on a fixed interest rate or you can pay based on an adjustable interest rate.

A fixed-rate mortgage provides you the same interest rate for the life of the mortgage. It is set at the time the loan is signed and stays the same for however long the mortgage is set to run for (typically 15 or 30 years).

For an adjustable-rate deal, the interest rate for the loan fluctuates along with overall interest rates as pegged to some standard like LIBOR as in..."the cost of your adjustable loan will be LIBOR plus 200 basis points, adjusted every quarter". So the interest shifts based on market conditions and based on the terms of the contract.

The fixed-rate option provides security, allowing the borrower to know what their payments will be...forever. The payments stay the same, no matter what happens in the interest rate market.

Meanwhile, a borrower with an adjustable-rate mortgage can see their payments change as interest rates move around. Getting this kind of mortgage is a type of gamble: the borrower is hoping that rates will go down and stay down, allowing them to pay less on the mortgage than if they had locked in a higher rate.

Many adjustable-rate mortgages have limits to the amount the rate can move around. These limits are called the "annual cap."

So say you get an adjustable-rate mortgage that starts off with a 5% interest rate and has a annual cap of two percentage points. In the first year, the bond market goes bonkers and overall interest rates spike by three percentage points. Theoretically, your mortgage rate should jump to 8%, but since you have the annual cap in place, it will only rise to 7%.

Caps come with strings attached: First, the cap also applies to the amount the interest rate can decline as well. If interest rates plunge, your rate might not drop as much, if you have a cap in place.

For instance, mortgage lender Freddie Mac outlines a "7/1 ARM with a 5/2/5 cap structure." ARM just means "adjustable rate mortgage." The "7/1" part indicates that your interest rate will remain steady for the first seven years, with the first adjustment set to take place in the eighth year. Adjustments will then continue on an annual basis after that.

The cap structure numbers - "5/2/5" - indicate that in that first adjustment in Year 8, the interest rate can move by 5 percentage points off the initial rate. It can then move by two percentage points per year in each subsequent year (that's the number two in the 5/2/5 set up). However, the rate can never move by more than five percentage points over the life of the mortgage (that's the last five there).