ARMs Changes and Caps
- Lenders usually adjust the interest rates on their ARMs every six or twelve months, using the mortgage-rate formula involving a number of factors. Some loans adjust monthly. (Monthly adjustments are usually a red flag for negative amortization loans.) In advance of each adjustment, the mortgage lender should send you a notice, spelling out how the new rate is calculated according to the agreed-upon terms of your ARM.
- The less often your loan adjusts, the less financial risk you're accepting. In exchange for taking less risk, the mortgage lender normally expects you to pay a higher initial interest rate.
Caps: Limits on interest rate adjustments
- Despite the fact that an ARM has a system for calculating future interest rates (by adding the margin to the loan index), bankers limit how great a change can occur in the actual rate that you pay. These limits, also known as rate caps, affect each future adjustment of an ARM's rate following the end of the initial rate.
- Two types of rate caps exist. Periodic adjustment caps limit the maximum rate change, up or down, allowed at each adjustment. For ARMs that adjust at six-month intervals, the adjustment cap is usually 1 percent. ARMs that adjust more than once annually generally restrict the maximum rate change allowed over the entire year, as well. This annual rate cap is usually 2 percent.
- Finally, almost all adjustables come with lifetime caps. You should never take on an ARM without a lifetime cap. These caps limit the highest rate allowed over the entire life of the loan. ARMs commonly have lifetime caps of 5 to 6 percent higher than the initial start rate.
When you take on an ARM, be sure that you can handle the maximum possible payment allowed, should the interest rate on the ARM rise to the lifetime cap.