Sometimes it is more important for you to have a lower initial rate, resulting in a lower payment, so that you will be able to qualify for the home you have chosen. Perhaps you plan to move in a few years and are not concerned about possible interest rate increases. Maybe you are confident that your income will increase enough in the coming years to compensate for periodic increases in your interest rate, and subsequently larger mortgage payments that accompany an Adjustable Rate Mortgage Loan (ARM). If the scenarios described above are similar to your situation, you may wish to consider the substantial savings available to you with an Adjustable Rate Mortgage (ARM). It’s important to note that you have the option of refinancing your loan at the completion of the fixed period, to a new ARM loan or a longer fixed rate term.
Adjustable Interest Rate Caps
Initial cap: The maximum amount that the interest rate can adjust the first time it’s changed after the fixed period.
Periodic cap: This puts a limit on the interest rate increase from one adjustment period to the next. The initial cap and the periodic cap may be the same or different.
Lifetime cap or ceiling: This puts a limit on the interest rate increase or decrease over the life of the loan, and all adjustable-rate mortgages have a lifetime cap. Although these limits are put in place for rate increases, rates can decrease, too. However, since the margin stays the same throughout the life of the loan and is added to the index to get the interest rate, the rate will never fall below the margin. With an ARM, your interest rate is fixed for a given period of time, depending on the term you have chosen, typically 1, 3, 5 or 7 years. ARM loan rates are typically lower than the longer fixed 30 year rate terms. Your interest rate will increase each year after completion of the fixed period. These predetermined adjustments define the amount of interest rate increase you may incur during each adjustment period, and also the maximum interest rate you could be charged over the life of the loan.
Adjustable-Rate Mortgage Cap Structure
Cap structure is a numerical representation of each cap for the loan. This is presented in a series of three numbers that represent the three caps: initial cap, periodic cap and lifetime cap.
For example, a common rate cap is 2/1/5, which breaks down like this:
Initial cap: Your initial interest rate can only change by up to 2% the first time it adjusts.
Periodic cap: Each change after that is limited to 1% every 6 months.
Lifetime cap: Throughout the rest of the loan term, the most the interest rate can increase or decrease is 5% from the fixed rate. So, if your original rate was 3.5%, your interest rate can only go up to 8.5% during the life of your loan. One cap limits the amount that your interest rate can go up during each adjustment period. For example, an ARM that adjusts annually may cap the yearly interest rate increases at 2 percent, meaning the adjusted interest rate can never be more than 2 percent higher than the year before.
The other cap sets the limit on the total amount of interest adjustments over the life of your loan. An ARM that has a lifetime rate cap of 6 percent, means that the highest adjusted interest rate you will ever be required to pay is no more than 6 percent above the original rate. Using this example, an ARM with an introductory rate of 5 percent and a lifetime cap of 6 percent, means that the highest interest rate you will ever pay would be 11 percent.
You will receive ample notice regarding these adjustments to your rate, allowing you to decide whether to continue at the present rate or refinance your loan to a lower rate.
