What is the purpose of a rate cap in an adjustable-rate mortgage?

In an adjustable-rate mortgage (ARM), a rate cap serves a crucial function by providing protection for borrowers against sudden and excessive increases in interest rates. When interest rates rise, the lender typically adjusts the borrower's interest rate according to the terms of the mortgage contract. However, without a rate cap, these adjustments could lead to significantly higher monthly payments that may become unaffordable for the borrower.

The rate cap limits the amount by which the interest rate can increase within a specific period, whether it be between adjustment periods or over the life of the loan. This safeguard helps borrowers manage their financial risk and plan their budgets more effectively, as they have a clearer understanding of potential fluctuations in their payment amount. For borrowers, this feature is vital in maintaining financial stability and ensuring that they can continue to meet their mortgage obligations even if market conditions change.