A lifetime cap is the guaranteed maximum interest rate that a lender can charge on an adjustable-rate mortgage (ARM) over the life of the loan. The interest rate on an ARM fluctuates based on a benchmark. Sometimes, the interest rate fluctuates as frequently as every month. To assure borrowers that the interest rate on their loans will never exceed a certain rate, the lender establishes a cap that is equal to the fixed loan rate plus a certain maximum percentage.
Lenders design different loan products in the residential real estate market to meet the needs of borrowers. Two of the main types of mortgage products are flat-rate mortgages and ARMs. Flat-rate mortgages offer the borrower a single interest rate that stays in affect for the life of the loan, which can be as long as 15 or 30 years. This type of loan provides the borrower with certainty regarding his periodic loans payments, but can also be an albatross if lower interest rate mortgages become available in later years.
To protect the borrower against the possibility that interest rates may decrease, he can choose to take out an ARM instead. An ARM uses a floating rate of interest that is tied to a benchmark that will rise and fall with the economic conditions in the country where the loan is made. The loan terms designate a popular ARM benchmark and a fixed percentage to be added to the benchmark percentage to establish the actual interest rate on the ARM at any time. In practice, the benchmark might fluctuate between two and three percent, for example, while the fixed rate on the ARM might be set at four percent. This scenario would result in a fluctuating interest rate on the loan between six and seven percent.
The way the lender offers to protect the borrower against a volatile benchmark is by setting a lifetime cap. This cap functions as a hard maximum rate of interest that can be charged on the loan. The lifetime cap is added to the ARM rate to determine the maximum rate. If the ARM rate is four percent and the lifetime cap is five percent, the interest charged on the loan cannot exceed nine percent, no matter how high the benchmark goes. As a practical example, if the benchmark rose to 6% for an ARM with a 4% interest rate and a lifetime cap of 5%, the maximum interest rate that the lender could charge the borrower would be 9%, even though the benchmark actually raises the fluctuating interest rate to 10%.