What Is an Annual Cap?

An annual cap is a legal limit on interest and rate increases for a given period, and also refers to limits on contributions to benefits accounts like pension plans. Annual caps may be set by law or under the terms of a contract associated with a financial activity like a mortgage. Such restrictions can prevent situations like payment shock, where borrowers are hit with a sudden increase that exceeds their ability to pay, and may be at risk of default on loans. In the case of contributions to retirement accounts, annual caps limit the exploitation of such accounts, to prevent tax evasion.

Annual caps in terms of interest and rate increases can be seen with mortgages, credit cards, and similar financial accounts. Under the terms of the contract associated with the account, the lender cannot raise interest or fees beyond the annual cap. This is especially important for adjustable rate mortgages, where the lender is allowed to adjust the interest rate in response to current market conditions.

Without an annual cap, the lender could potentially raise the interest rate infinitely, which could create an unfair situation for the borrower. Annual caps such as 5% prevent lenders from raising interest unreasonably. They allow for some rate adjustment to benefit the lender, while also providing an adjustment period for the borrower to get used to larger payments. Thus, on a mortgage with 4% interest and a 5% cap, the borrower knows that the interest rate will not rise above 9% that year, and can plan accordingly.

In benefits programs, the annual cap limits the amount of contributions people can legally make to protected accounts. In these accounts, tax is not assessed on income deposited into the account, to create an incentive to save for retirement. This could create a situation where people deposit very large sums into retirement accounts to avoid taxes, and annual caps prevent this problem. People can add extra contributions if they want to, but these will not be subject to tax benefits.

The lifetime cap is a closely related concept. Many benefits plans like health insurance limit the total amount paid out over the lifetime of the policy. Insurance companies use careful risk assessment to limit their chances of making a large payout, but the lifetime payout can provide added protection. Once payouts hit a certain amount, the insurance company is no longer liable, and the policyholder must pay out of pocket. Some policies also have an annual cap to limit spending within a given benefits period.