A cap that is placed on a resetting or periodic interest rate. It is usually purchased by a borrower who desires to restrict upward interest rate fluctuations beyond a specific limit (the capped level). For example, in an adjustable rate mortgage (ARM), interest rates may fluctuate from one adjustment period to the next, exposing the borrower to interest rate risk: the risk that interest payment would move up beyond a sustainable level. The cap represents the maximum interest rate adjustment allowed during a given period over the term of an adjustable rate loan.

For example, if an ARM has a periodic rate cap of 4/1/5, the first figure (4) is the initial cap; the second (1) is the periodic cap; and the third (5) denotes the term of the cap. If the loan’s interest rate was 5.5 percent, then the initial cap implies that the first adjustment is the stated rate plus or minus four percent–so it can move as high 9.5 percent or as low as 1.5 percent (a remote probability, anyway). The periodic cap implies that the second and subsequent adjustments would be the ARM’s rate (5.5 percent) plus or minus one percent–so it will not exceed 6.5 percent and will not drop below 4.5 percent. Over the term of the cap, the rate can never move above or below the stated rate (5.5 percent) plus or minus the initial cap (four percent).