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ARM Caps Can Curtail High Payment Shocks

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Would-be homebuyers shopping for a mortgage often focus on the size of their monthly payments, but more goes into the decision than dollars. Determining how much you can afford, the level of risk you’re willing to take on and how long you plan to stay in a home will influence the type of mortgage you’re seeking.

Fixed vs. adjustable rate mortgages

One of the first things you’ll need to decide is whether to apply for a fixed or adjustable rate mortgage (ARM). With a fixed-rate mortgage, the interest rate doesn’t change while you’re repaying the loan. Knowing what your mortgage payments will be for the next 10 to 30 years can help with your long-term financial planning, and provide risk-averse buyers with a sense of stability and continuity.

An adjustable rate mortgage, on the other hand, includes a lower interest rate for a certain period of time, after which the interest rate may go up or down. How much it goes up is capped — we’ll discuss how ARM rate caps work and whether an ARM is right for you.

ARM rate caps

Caps are there as a form of protection — they set parameters for how much interest you’ll be charged over the life of your mortgage. ARMs typically have three rate caps:

Initial adjustment cap: The maximum percentage point increase for your first interest rate adjustment.

Subsequent adjustment: The maximum percentage point increase for follow-up adjustments over the life of the loan.

Lifetime adjustment: The maximum interest rate that your ARM could ever reach.

To better understand these ARM cap categories, here’s an example:

Let’s say that you have an ARM with a base interest rate of 3.5%, an initial rate cap of 2%, a periodic rate cap of 2% and a lifetime cap of 9.5%. If at the time of your first adjustment, the index plus the margin is 6%, your new interest rate will only increase to 5.5% because of the 2% initial adjustment cap. It will only increase by a maximum of 2% for follow-up adjustments as well, and it will never increase past 9.5%.

A note about indexes and margins

We’ve used terms like “index” and “margin,” but what do they mean when it comes to ARMs?

Index: Adjustments like the ones we discussed above are tied to the financial markets and the values of certain indexes, such as the London Interbank Offered Rate or LIBOR. Other major indexes include the 11th District Cost of Funds Index (COFI) or the maturity yield on the one-year treasury bill. Variations related to those indexes can impact your monthly payment.

Margin: When it’s time for your ARM’s rate to reset, the value of the index is added to another component called the margin. The margin is agreed upon by you and your lender. It’s a percentage that’s added to the value of the loan’s index to come up with what’s called the fully-indexed rate.

When an ARM makes sense for you

ARMs are attractive because of the low initial rate, which may draw buyers who plan to stay in their home for only a short while. Some buyers opt for ARMs when they don’t expect to be in the house past that introductory period.

Nathan Pierce, a certified mortgage specialist in the Salt Lake City area, presented the example of military service members who anticipate being transferred to new installations every three to five years. They might choose an ARM for the low initial rate and plan to sell the house before the adjustable rates begin.

However, it’s important to look past the temporary fixed rate, said LendingTree Chief Economist Tendayi Kapfidze. “It’s not always about the cheapest loan,” he said. “It’s really about your financial situation and, importantly, your appetite for risk.”

Borrowers can be overconfident about their future earnings prospects, not to mention their abilities to foresee the future. Factors outside your control can constrain your ability to sell the house or set aside as much savings as you had hoped to manage any impending rate increases, according to Kapfidze. Without a clear understanding of the worst-case scenario, you can find yourself struggling to keep up with your mortgage.

“People like to think they know these things with a degree of certainty that really is kind of impossible to have in the real world. Circumstances change, your job may change, the economy may change. Even the neighborhood where you bought the house may change,” Kapfidze said.

“The notion that, ‘I’m going to sell this house in three years or four years and the adjustable rate only kicks in after five years’ —  I mean, it’s possible, but that doesn’t mean you’re not taking a risk. Just because you believe that’s what you’re going to do doesn’t mean you’ve eliminated the adjustable rate risk.”

Kapfidze said people often overestimate their abilities to control their future prospects and underestimate how long they’re going to be in a particular property. Kapfidze himself purchased a condo in 2004, assuming he would sell it within five to seven years. But during the housing crisis of 2007-2009, the property’s value fell below what he had paid for it. The valuation remained low for so long, he ended up hanging onto it and still owns it today.

“My whole mortgage scenario that I thought I was gaining out when I got it didn’t play out the way I thought it would,” he said. Although he benefited from decreased interest rates on his own ARM during the post-recession years, his experience still serves as a reminder that there are no guarantees when it comes to selling property on your own schedule.

Even the protection of ARM caps can be limited. “There’s so many variables out there that as a homebuyer, your ability to reasonably predict the cap of rates … is zero,” Kapfidze said. “So don’t do things thinking you know where rates are going to go or how the economy is going to play out and affect your decision to either dispose of or hold a property.”

Comparison shopping for an ARM loan

Whether you’re considering an ARM or a fixed-rate mortgage, one of the most important things you can do is to shop around. When evaluating the different types of ARMs, the Consumer Financial Protection Bureau recommends not only comparing rate caps among lenders, but requesting that your lender calculate the highest possible payment you might make. That number can help bring the commitment you’re making into full focus, allowing you to decide whether the house you’re about to buy is truly within your budget.

A good mortgage calculator can help you factor in other costs of homeownership, such as taxes and insurance. The Federal Reserve Board also has a handy guide to understanding ARMs.


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