A monthly payment cap acts like a safeguard for homeowners with adjustable-rate mortgages (ARMs), limiting how much their monthly principal and interest payment can increase during each adjustment. For example, with a 7.5% cap on a $1,500 payment, your payment cannot increase by more than $112.50 at the next adjustment. This feature provides short-term payment stability but carries a significant risk: unpaid interest is added to your loan balance, a process called negative amortization.
In an ARM, the interest rate fluctuates based on a financial index. When rates rise, so does your mortgage interest rate. The monthly payment cap stops your payment from jumping too much at once, but it doesn’t cap the interest rate increase itself. If your higher interest rate requires a $200 payment increase, but your payment cap only allows $100, the remaining $100 is added to your loan principal.
This can increase your total debt over time, as you effectively pay interest on unpaid interest. Negative amortization erodes your home equity and can lead to a larger loan balance than at the start.
For example, suppose your current monthly payment is $2,000 and your ARM has a 7.5% payment cap. When interest rates rise, your lender calculates your new fully amortizing payment should be $2,250. However, applying the 7.5% cap means your payment can only increase by $150 to $2,150. The $100 difference is added to your loan balance, increasing your debt.
It’s important to distinguish monthly payment caps from interest rate caps. Interest rate caps limit how much the rate can rise per adjustment and over the life of the loan, typically preventing extreme rate changes (such as with a “2/2/5” cap structure). They protect you from runaway interest but do not prevent larger payment increases. Payment caps, by contrast, limit payment increases but can cause negative amortization.
According to the Consumer Financial Protection Bureau (CFPB), interest rate caps are standard on most modern ARMs, providing safer protection for borrowers. Payment caps were more common in older and riskier loan products, such as Option ARMs offered before the 2008 financial crisis. Due to their risks, they are less common today.
Loans with payment caps often include a recast provision. After several years or if the loan balance grows beyond a set percentage (typically 110% of the original balance), the lender recalculates the payment to fully amortize the loan. This can result in a significant payment increase, known as payment shock.
If you have an ARM or are considering one, check your loan documents carefully. Ask your lender if your loan includes a monthly payment cap, an interest rate cap, and whether negative amortization is possible. For more details on ARMs, see our article on Adjustable-Rate Mortgages, and to understand how negative amortization affects your loan, visit our page on Negative Amortization.
Understanding these features can help you avoid financial surprises and better manage your mortgage payments.