Sometimes known as a lifetime interest rate cap, an interest rate ceiling is the maximum rate of interest that a lender can charge a borrower on an adjustable-rate mortgage. The identification of this cap or ceiling is normally identified in the terms and conditions found in the mortgage contract. Typically, the interest rate ceiling rate is presented as a percentage, making it easy for the borrower to understand this maximum interest rate and how it relates to the outstanding balance at any point during the life of the mortgage.
Strictly speaking, an interest rate ceiling and an interest rate cap are not the same. The ceiling basically establishes the highest rate that can be applied to the balance of the loan at any given point in time. With an interest rate cap, the figure represents the highest percentage above or below the initial interest rate that can be applied during any given adjustment period.
For example, if the terms of the mortgage contract call for a cap of 4%, and the initial interest rate is 5%, the lender can never adjust the rate to more than 9%, regardless of how much the average mortgage rate in the nation may move. By contrast, if the contract contains an interest rate ceiling of 10%, then the lender can charge up to that percentage in interest should circumstances merit, regardless of what the initial interest rate for the mortgage may have been.
One of the benefits of an interest rate ceiling is that the borrower can always determine the worst case scenario in terms of the amount of interest that could be assessed on the loan. This means looking not only at the initial interest rate, but also having some idea of how interest rates in general are likely to move during the life of the mortgage. By locking in a maximum amount of interest, there is a good chance that the borrower can avoid upward adjustments of the rate that would mean paying more than the current average rate in the nation, especially if economic factors should occur that cause mortgage rates to climb unexpectedly.
It is important to note that even though a mortgage contract may include an interest rate ceiling, there is no guarantee that the lender will ever impose this maximum rate. As long as average interest rates remain lower that the ceiling and the economy is relatively stable, the chances of the borrower having to pay that interest rate during an period is highly unlikely. By allowing for the possibility of the ceiling being reached at some point, the borrower can structure the household budget to allow for the contingency, making it possible to set aside the funds not used during each period in which the lender assesses a lower rate of interest, possibly using that extra money for additional mortgage payments and retiring the debt early.