What is meant by the term "cap" in the context of an adjustable-rate mortgage (ARM)?

In the context of an adjustable-rate mortgage (ARM), a "cap" refers specifically to a limit on how much the interest rate can change over a specified period. This is a critical feature for borrowers because it provides a level of predictability regarding their monthly payments, even as market interest rates fluctuate.

For ARMs, there are typically two types of caps: one that limits how much the interest rate can increase at each adjustment period and another that sets a maximum increase over the life of the loan. These caps are essential in protecting the borrower from significant spikes in interest rates, which could lead to unaffordable payments. For example, if an ARM has a cap of 2%, this means that at each adjustment, the interest rate cannot increase by more than 2%. This feature helps borrowers manage their financial risk associated with interest rate changes.

Understanding the concept of caps is vital for anyone considering an ARM, as it influences the overall cost of borrowing and the potential for payment fluctuations.