Interest Rate Ceiling
What it is:
How it works (Example):
A potential homebuyer contracts with a mortgage lender to secure a loan. If it is an adjustable rate mortgage, the mortgage contract spells out the details which normally include the maximum interest rate charged. This will include the maximum annual rate as well as the lifetime (cap) maximum. The rate can never go beyond either one of these two ceilings.
For example, a homebuyer takes out a mortgage with an annual increase cap of 2% and a lifetime interest rate ceiling or cap of 10%. This means that if the prevailing interest rate goes up every year after he initially takes out the mortgage, his rate will never increase more than the agreed upon 2% annually or go beyond the 10% rate over the life of the mortgage.
Why it Matters:
Having an interest rate ceiling is preferable when the rates are expected to decrease during the life of the mortgage, or, if the homeowner will not be living in the home for the long term. The downside would be if one tries to refinance the mortgage if the market starts dropping and the homeowner is still paying a higher percentage.