Understanding Adjustable Rate Mortgages Part II

September 21, 2009 · Posted in News For Homebuyers

In Part II of this three-part series, I will discuss how “Caps” work on an ARM (Adjustable Rate Mortgage).

A cap on an ARM determines the maximum amount your mortgage rate can adjust, or “what it caps out at.” As mentioned in Part I of this series, a traditional fixed-to-adjustable mortgage is fixed for a period of time then adjusts on a regular schedule.

There are three caps on a mortgage. Here is how each one works.

Initial Adjustment Cap

When your loan reaches its first adjustment after its initial fixed period, the first rate adjustment is the “Initial Adjustment” of your loan. The Initial Adjustment Cap will determine the maximum your loan can adjust the first time. If the Cap is 2%, then your loan cannot move more than 2% from your start rate, up or down.

Let’s say you have a 5/1 ARM with a 4.5% interest rate and a 2% Initial Adjustment Cap. After 5 years, the new rate can adjust from 4.5%. However, it cannot move higher or lower more than the 2% Initial Adjustment Cap. That means the lowest your loan can adjust is to 2.5% and the highest it can adjust is to 6.5%.

Periodic Adjustment Cap

The Periodic Adjustment Cap is the maximum amount your loan can adjust each time after the initial adjustment. Each time the loan adjusts the Periodic Adjustment Cap limits how much your loan can adjust from the previous rate you were just paying.

Let’s use the same 5/1 ARM loan above as an example. Let’s assume this 5/1 ARM has a 1% Periodic Adjustment Cap along with the 2% Initial Adjustment Cap. Without going into margins and indexes (This will be discussed in Part III of this series), here is a worst case scenario rate schedule for 7 years.

5 years at- 4.5%

1 year at- 6.5% (Initial Adjustment)

1 year at- 7.5% (Periodic Adjustment)

In a best case scenario, here is your rate schedule for 7 years.

5 years at- 4.5%

1 year at- 2.5% (Initial Adjustment)

1 year at- 1.5% (Periodic Adjustment)

Lifetime Caps and Floor Rates

A Lifetime Cap is the maximum your loan can adjust over the life of the loan from your start rate. This means your rate will never exceed the Start Rate + the Lifetime Cap. If your ARM starts at 4.5% and has a Lifetime Cap of 5%, your rate will never go above 9.5% regardless of how many times it adjusts and how long you keep the loan.

Your Floor Rate is the lowest your rate can go. This means no matter how much your rate adjusts down, it will never go lower than your Floor Rate.