Cap and Carryover Examples

Interest caps are a big and important aspect of adjustable rate mortgages (ARMs). Without caps, many people would be far less likely to take the risk of going with an adjustable rate mortgage. This is because they prevent monthly payment costs from rising too much (overall caps) or too quickly (periodic caps). While we have looked at the details of caps in another section, it is helpful to have some examples of how caps might work in practice.

Suppose you have an ARM with a periodic cap of two percent. This means that no matter what your ARM’s index is doing at readjustment time, your rate for that period cannot be raised more than two percent. Suppose your initial rate was ten percent and your monthly payment was $570.42. Now suppose the interest rate increases by three percent. If you didn’t have a cap, your second year payments would be $717.12 per month, a monthly increase of almost $150. With the periodic cap in place, your second year payments will be $667.30.

Keep in mind that this does not mean you will never have to pay the extra one percent you saved in year two. Instead, the one percent will carry over to the next year. Suppose you are paying your $667.30 per month in the second year. The period ends, and it is time to readjust again. The index has stayed the same, but you will still have an extra one percent of interest added on from the year before. You will now be paying thirteen percent interest rather than twelve percent, and your monthly payment will increase to $716.56. The one percent that was not added in year two has carried over to year three.

Because of carryover, periodic caps don’t save you much money overall, they just keep your payments and rates from skyrocketing too quickly for you to keep up. Overall caps, on the other hand, do set an outer limit. Suppose you have the same loan (beginning at ten percent, initial monthly payments of $570.42) with an overall cap of five percent. If your interest rate increases one point at each adjustment over the next nine years, your payment in the tenth year would be $813.00 at fifteen percent interest with the five percent overall cap. Without an overall cap, the monthly payment would be a staggering $1008.64 at nineteen percent in year ten.