Tuesday, October 31, 2006

Adjustable Rate Mortgages - Limits

In a comment to a previous post on Adjustable Rate Mortgages (ARMs), a reader asked, “Is there some kind of a interest rate cap for ARMs ?” Here was the answer:

Yes, there are limitations to interest increase and decrease (in a declining rate environments) amounts. There are usually two caps, one for each adjustment and one for the life of the loan. The adjustment cap is the maximum change that can occur for the periodic changes – typically around 1-2% but can be as high as 5%. For example, if a loan has a 2% adjustment cap and interest rates rise 4%, the loan interest is only increased 2%. The life of the loan cap is the maximum change from the initial rate that can happen over the full term – typically around 5%, I think. So if your initial rate is 5.5%, the minimum and maximum rates anytime during the life of the loan are 1.5% (we wish:-) and 10.5% (arrgh) respectively.

There are also limitations the frequency of adjustment.

Fixed Rate Period. ARMs typically have a period when the interest interest is fixed. Typically, it is 1, 3, 5 or 7 years. The longer the fixed period, the higher the intial interested rate.

Adjustment Period. After the fixed rate period, ARMs will adjust once or twice a year. Usually, 1 indicates a yearly adjustment, and a 6 indicates an adjustment every 6 months.

For example, an ARM with a 3 year fixed period and adjustment every year after 3 is a 3/1 ARM.

The issue is that many people use an ARM because it has a lower payment than a fixed rate mortgage, and they could not afford or qualify for the fixed rate mortgage. With interest rates rising over the last 3 years, some of these people are experiencing the same affordability difficulty again, even with caps.

This is not financial or real estate advice. Please consult a professional advisor.

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