Initial Interest Rate Cap

Fixed-rate loans have a constant rate for the entire term. You have a 5-year loan with a 5% interest rate. With that loan, you owe 5% every year for each of those five years, no matter what.

An adjustable-rate loan works differently. The interest rate moves around, often tied to movement in overall rates. However, many of these loans have limits on how far rates can move around at any given time. It's not a free-for-all. The adjustments happen at predetermined times, usually in controlled chunks as set out in the loan terms.

An initial interest rate cap defines one of these limits on the rate movement. It's the amount the rate can move at the loan's first adjustment period.

A common structure for these adjustable-rate loans goes something like this:

A 5-year loan with an initial rate of 5%. That 5% rate stays put for the first two years, then adjusts every year after that based on changes in the prime rate. It has an initial interest rate cap of two percentage points. Under that setup, the first adjustment would occur two years into the loan. At that point, it can move as much as two percentage points, possibly rising as high as 7% or falling as low as 3%.

If rates rise by half a percentage point, the interest rate would rise from 5% to 5.5%. It just tracks the overall move in rates. However, with the cap, even if interest rates spike 10 percentage points in those two years, the loan rate can't go above 7%. The initial rate cap limits the amount it can move.