Annual Cap Law and Legal Definition

“Annual cap” is a clause found in the contract of an adjustable-rate mortgage (ARM) that limits the possible increase in the loan's interest rate to a certain amount each year. It is usually defined in terms of rate. However, the dollar amount of the principal and interest payment can be capped as well. Annual caps are designed to protect borrowers against a sudden and excessive increase in the amount of their monthly payments when rates rise sharply over a short period of time. Although this type of cap can lead to negative amortization in some cases, a loan with a dollar cap can only increase by so much as well.