Adjustment Caps

Q.  Would you explain Adjustment Caps?

 A.  Adjustment Caps apply to Adjustable Rate Mortgages (ARMs). 

Most ARMs have fixed interest rates for differing periods of time e.g., 3, 5, 7, & 10 years.  When that period is up they adjust according to the index they’re tied to.  In order to make ARMs more appealing to borrowers, and to provide some consumer protection, most of today's ARMs offer maximum or "caps" on the amount that rates can change.  The adjustment cap notation is often expressed by three consecutive numbers, like 5/2/5.  The first number refers to the maximum interest rate change during the first adjustment period, the second number, to the maximum interest rate change during subsequent adjustment periods and the third number refers to the maximum interest rate change over the life of the loan.  The periods of adjustment vary with the loan: for a 3/1 or a 5/1, it would be annually or once a year; for a 5/6 or 7/6, it would be every 6 months or twice a year.  Thus, a 5/1 ARM with a start rate of 6% (for 5 years) and a margin of 2.25% with adjustment caps of 5/2/5 means that in year 6 (the first adjustment period) the index could adjust upward 5%, in year 7 (the subsequent adjustment period) it could adjust 2%, but over the life of the loan fully-indexed rate (margin + index) could never exceed more than 5% above the start rate.  So, if this same loan were tied to the 6-month LIBOR index and the index had increased from 4.69% (today’s rate) to 6.69% then the new fully indexed rate with the adjustment would be: 2.25% (the margin) + 6.69% (the index) = 8.94% and the rate could go up as much as 2% at the beginning of year 7 to 10.69%, if interest rates had risen substantially during year 6.  But, it could never exceed 11% (6% start rate + 5% lifetime cap).  When mortgages do adjust, borrowers sometimes experience what is termed payment shock because the rate has adjusted upward 2-3%.

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