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Frequency of Changes

February 23, 2012

The frequency of rate changes for an ARM loan depends on the terms. As detailed below, the product name usually indicates the frequency of rate changes. For example, a 3/1 ARM means that the rate is set for the first three years and cannot go up or down. After those first three years, the rate adjusts every year. The same would be true of a 5/1 ARM with the first five years set and the rate adjusting every year after. Because there are numerous variations of ARM loans, it is not possible to cover every one in existence.

Caps

Most of today’s ARM loans contain provisions known as “caps”. These caps place maximum limits on the amount rates can change. This takes some of the risk out of having an adjustable- rate loan and often makes the product more attractive to the consumer.

Interest Rate Caps

Interest rate caps do just as the name describes: place limits on how high the interest rate on an ARM may ever be. This is of great importance to the borrower because the interest rate can never go above the worst-case scenario.

Rate Adjustment Caps

A rate adjustment cap focuses on the amount the interest rate is allowed to change from one adjustment period to the next. The interest rate cap on a loan may be 9.5% for the life of the loan, but it may only be allowed to adjust—up or down—2% between two adjustment periods.

Life of Loan Caps

A life of the loan cap sets the maximum the interest rate may go above the initial rate over the entire life of the loan.

Whenever there is a cap on an ARM loan, it serves to modify the formula used to calculate the interest rate. The existence of caps is utilized in the worst-case scenario analysis that really allows the borrower to assess what the payment would be like if the ARM rate went to the ceiling. However, this may not give the borrower the most accurate information because when a cap is in place, the interest rate change is determined by one of the following methods, depending on which one yields the smallest charge:

INDEX + MARGIN

or

RATE + CAP

(Whichever charge is smaller)

Initial Adjustment Cap

Particularly in programs where the initial interest rate is set for a longer period of time, the transitional cap—when the first rate change occurs—may be different from the caps addressed as the loan adjusts annually thereafter. The rate may be allowed to increase to the lifetime cap after the initial adjustment, and subsequent adjustments may be based upon that new rate. This must be investigated because, due to borrower concerns about the frequency of changes, the change caps may be overlooked as an unimportant factor. 

Payment Caps

Payment caps dictate the rate at which the borrower is allowed to make payments, not the interest rate. Payment capped ARM loans may allow for an increase in interest rates almost immediately following the initial rate. This may cause the capped payment to be insufficient to cover the new total for interest due. This failure to cover the interest results in a shortfall, known as negative amortization. This shortfall in payments is then added to the principal balance of the loan.

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First, Complete out a loan application on our website
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-Scroll to the middle of the page and Click on 3. Full Application
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