Again, at the anniversary (one-year, six-month, etc., depending on period) of the ARM loan, the lender adjusts the interest rates and payments by adding the constant loan margin to the index rate.
However, this raw index-plus-margin number is not necessarily the borrower's new interest rate. This preliminary rate must be within the restrictions established by the specific loan program's caps. The new interest rate and monthly payment is the index plus margin, less whatever restrictions are required by the program's caps.
Caps protect the borrower by limiting the movement of the interest rate, payments and principal balances, normally associated with ARM loans. There are four types of caps that can be involved with each ARM loan:
The periodic cap limits how much the loan's interest rate may change from one period to the next. The norm for most conforming lenders is a periodic cap of one (1) or two (2) percentage points.
For example, if the loan program specifies a periodic cap of 2.00 percentage points, then the borrower's loan rate cannot increase (or decrease) by more than two (2) percentage points from one period to the next.
Thus, if the borrower had an interest rate of 6.50%, even if the index shot up to 19.00%, the most that the borrower's new rate can be is 8.50%.
The lifetime cap establishes a maximum—and sometimes minimum—level that the interest rate may never surpass during the entire life of the loan. Most conforming loan programs set a lifetime cap of five (5) or six (6) percentage points, applied to the start rate.
For example, an ARM loan with a six (6) percent life cap and a starting rate of 5.50% would have a maximum limit of 11.50%. This means that even if the index would increase to 17.50% (which has happened in recent history), this ARM loan's interest rate would never exceed 11.50%.
For many ARM loans, the start rate is the lifetime floor cap.
The payment cap limits how much the loan's monthly payment (not rate) may change from one period to the next. The typical payment cap, if any, would be 7%-12% of the current payment. For example, if an ARM loan had a payment cap of 7% and a current mortgage payment of $100, the new payment would be a maximum of $107 per month ($100 * 1.07).
But payment caps do not limit the increases of interest rates. Consequently, payment caps may induce negative amortization, which means that the principal balance increases instead of decreases. Check the ARM disclosure to be sure. Just because the payment increases are restricted does not mean that the interest calculated need not be paid.
The principal cap often accompanies loans with payment caps, by placing a ceiling on negative amortization, so the principal amount increase will not exceed 125% of the original loan balance.
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