Interest rate cap: what it means for ARM

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If you are looking to save on a home loan, you might be intrigued by the low starting rates on an adjustable rate mortgage (ARM). But while ARM rates are initially low, they can also rise over the life of the loan.

Interest rate limits protect you from runaway rate hikes, and it’s important to understand how they work if you’re buying adjustable rate mortgages.

Here’s what you need to know about interest rate caps:

What is the interest rate ceiling?

The interest rate cap limits how much your interest rate can rise by adjustable rate mortgage… With ARM, the interest rate starts at a low fixed rate and then rises or falls periodically.

For example: On the 5/1 ARM, the interest rate remains fixed for the first five years of the loan. After a fixed period, the interest rate can be increased or decreased once a year until the end of the loan term.

And when the rate changes, so does your monthly mortgage payment. Interest rate limits can protect borrowers from the shock of larger mortgage payments because they prevent rates from rising above a certain limit.

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How ARM interest rate limits are structured

Adjustable rate mortgages usually have some kind of cap structure that indicates how much the interest rate can rise at different points in time. Housing loan term.

The limits on adjustable rate mortgages are set by the lender. They are usually represented as a series of three numbers, such as 2/2/5, that represent each limit: an initial limit, a periodic limit, and an expiration limit.

This is how these caps work:

Initial adjustment cap

The initial adjustment cap limits mortgage rate may rise on the first change after the expiration of the fixed rate period.

Your lender sets this interest rate limit, but the Consumer Financial Protection Bureau says it’s usually between 2% and 5%.

For example, let’s say you get an ARM 5/1 with an initial flat rate of 3.5% and a 2/2/5 cap structure. Your interest rate can rise up to 5.5% in the sixth year of the loan term.

Subsequent adjustment of the limit

The subsequent adjustment limit limits how much the mortgage rate can rise in each adjustment period after the first.

This limit is most often set at 2%, although it varies depending on the lender and the loan. Take a look at your 5/1 hand with a 2/2/5 cap structure. Your rate has increased to 5.5% in the sixth year, and in the seventh year it may increase to no more than 7.5%.

To learn more: 30 Mortgage Terms You Need to Know: The Complete Glossary for Home Buyers

Lifetime adjustment cover

The Lifetime Adjustment Maximum determines how much your mortgage rate can increase over the life of the loan.

The maximum life is usually 5%, although some lenders set a higher limit. In the example ARM 5/1, which starts at 3.5% and has a 2/2/5 cap structure, the interest rate can never exceed 8.5%.

How to Compare Rate Limits When Selecting ARM

When you buy an adjustable rate mortgage, two lenders may offer the same starting interest rate, but different rate caps. One may turn out to be more expensive, so it is important to go beyond the interest rate limit and find out how much the interest rate might rise.

Clue: Ask the lender to calculate the highest payment you will be required to make on the loan and find out if your budget can absorb this increased payment.

You can also check your loan appraisal, a document that the lender provides within three business days after applying for a mortgage loan. See Page 1 in the “Loan Terms” section.

Next to the interest rate, the document will indicate whether the rate may increase after the close. It will also tell you how long the speed will be fixed, how often it can be increased, and how high it can be stretched.

ARM Loan Assessment (Loan Terms)

Is ARM Right For You?

When mortgage choice, you will need to choose between an adjustable rate and a fixed rate. Typically, adjustable rate mortgages benefit home buyers who plan to sell their home or refinance the mortgage before the end of the fixed rate period.

Clue: ARM can also make sense if you can pay more to the primary person during the flat rate period.

On the other hand, a flat rate can benefit those who plan to stay home for a long time and prefer a predictable monthly mortgage payment. If your budget is already tight, you may not be able to sustain the rate hike.

Here are the pros and cons of ARM to consider:

pros Minuses
Lower monthly mortgage payments initially Your monthly mortgage payment may increase
Reduce interest costs initially Increase in interest expenses in the long term
Rates may drop, resulting in lower monthly mortgage payments. ARM is usually harder
You can repay your loan principal faster Payments may become unavailable

When choosing between ARM vs Fixed Rate Loanask yourself these questions:

  • What Happens to Mortgage Rates? Interest rates are constantly changing, but you can track their overall trajectory over time. Adjustable rate mortgages can make sense if mortgage rates go up. This is because the difference between regulated and fixed rates is more pronounced, so you can find a lot on ARM.
  • Can I make additional payments during the flat rate period? When you have a low interest rate mortgage, most of your monthly payment goes towards paying off the principal. If you can make additional payments while your rate is low, then you can pay off most of your debt and save more money in interest in the long run.
  • How long do I plan to live in the house? ARM can be a good option if you plan to move before the end of your flat rate period. For example, people who move frequently to work can get an adjustable rate mortgage. But there is some risk here, because you will not be able to sell the house when you plan.

Learn more about ARM:

about the author

Kim Porter

Kim Porter is an expert in loans, mortgages, student loans and debt management. She has been featured in US News & World Report, Reviewed.com, Bankrate, Credit Karma and others.

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