Adjustable rate ceilings or caps and floors can provide benefits such as lower mortgage rates, but it's important to understand how and when your ARM mortgage rate can change. These factors affect how adjustable mortgage rates change:
- The financial index used to determine your ARM mortgage rate and how that index performs
- The margin lenders add to the financial index.
- The start rate (also called an introductory rate or "teaser" rate).
- The adjustment period, which specifies how often the rate resets – annually, every six months, etc.
- The ARM rate cap or ceiling, which determines how much a rate can increase from one adjustment to the next.
- A lifetime cap, which limits how high the rate can go over the loan's lifetime.
- An ARM floor, which protects the lender by limiting how low the interest rate can go.
Without floors and ceilings, ARMs would be less attractive and riskier for all parties.
How ARM Ceilings Work
ARM mortgage borrowers are typically more concerned with adjustable rate ceilings, also called rate caps. These protect borrowers by eliminating sharp spikes in the rate, which could make the loan unaffordable.
Here's how all the factors listed above come into play. Suppose the Smith family buys their home with this $200,000 loan:
- It's a 5/1 ARM, which means the Smiths' rate won't reset until Year Six.
- The start rate is 2.25 percent.
- The index used is the 1-Year LIBOR. At the time of this writing, the index is .69 percent.
- The loan's margin is 2.00 percent.
- The loan has period caps of two percent, and a six percent lifetime cap.
- The loan has a 3.00 percent floor.
- The initial payment is $764.49
In Year Six, assume that the LIBOR index has increased to 5.5 percent. The new rate, then, would be the index (5.5 percent) plus the margin (2.00) percent. So the rate in Year Six would be 7.5 percent. Except that it won't because the caps means the rate cannot go higher than two percent over the previous rate. So 2.25 percent plus 2.00 percent equals 4.25 percent.
How ARM Floors Work
ARM floors work in a similar way. If instead of hitting 5.5 percent, suppose the LIBOR index only edged up to .75 percent. The index plus the 2.00 percent margin equals 2.75 percent. That would be the new interest rate, except that this loan has a 3.00 percent floor, which means the loan cannot reset to a rate lower than 3.00 percent.
Shopping for an ARM Mortgage
When you shop for an adjustable rate mortgage, you can't just compare the interest rate and costs the way you would for a fixed-rate home loan. Ask your lender for this information (or look it up yourself):
- What are the index, and margin for this loan?
- If this loan was resetting today, what would the rate be?
- What is the historical average of the index being used?
- What is the highest and lowest the interest rate can be?
The answers to these questions can help you understand your loan and predict how it might change. For example, the answers to the Smiths' questions are:
- Index, .69 percent, margin 2.0 percent.
- If resetting today, the rate would be 3.0 percent because of the loan's floor.
- The historical average of the 1-year LIBOR is 3.89 percent.
- The highest and lowest rates for this loan are 8.25 percent (the start rate of 2.25 plus the lifetime cap of 6.0 percent) and 3.0 percent (the loan's floor).
If the index were to hit its average value of 3.89 percent, the loan's interest rate would be 5.89 percent.
When you shop for ARMs, you need to account for your time-frame – for example, if you plan to sell the property within five-to-seven years, the long-term behavior of these loans is less important than if you plan to keep your house for a couple of decades. When you compare ARM loans, use the shopping section of the Good Faith Estimate disclosure. It allows you to input this information and compare loans more easily.