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When it comes to finance and investments, it’s essential to know the various terms and instruments you may encounter. One of those terms is “cap.” In finance, a cap is an acronym for “capitalization.”

In its simplest form, a cap is a limit on the interest rate that a borrower must pay on a variable rate loan or bond. Caps are commonly seen in adjustable-rate mortgages (ARMs) and other financial instruments where the interest rate changes over time. The cap sets a maximum amount for how high the interest rate can go.

Types of Caps

There are different kinds of caps, including:

Initial Cap: A cap on how much the interest rate can increase at the first adjustment period.
Periodic Cap: A cap on how much the interest rate can increase at each adjustment period.
Lifetime Cap: A cap on how much the interest rate can increase over the life of the loan or bond.

How Caps Work

Cap limits are set by the lender or bond issuer and can vary depending on the instrument and the market. For example, an adjustable-rate mortgage may have an initial cap of 3%, meaning the interest rate can only increase by a maximum of 3% at the first adjustment period. The periodic cap, in this case, may be 2%, meaning the interest rate can only increase by a maximum of 2% at each subsequent adjustment period.

The lifetime cap is the most crucial cap for borrowers because it sets the maximum interest rate that can be charged over the life of the loan or bond. This means that even if interest rates skyrocket, the borrower’s interest rate can never go above the lifetime cap.

Caps are a fundamental concept in finance and investments, especially for those who deal with adjustable-rate instruments. Understanding caps can help borrowers make better financial decisions and avoid excessive interest rate charges. It’s important to remember that caps are not the only factor to consider when evaluating financial instruments, and borrowers should always do their due diligence before making any investment decision.