Overall caps, which
limit the interest-rate
increase over the life of
the loan.
By law, virtually all
ARMs must have an overall
cap. Many have a periodic
interest-rate cap.
Let's suppose you have
an ARM with a periodic
interest rate cap of 2%.
At the first adjustment,
the index rate goes up
3%. The example show what
happens. (Assumes a loan
in the amount of $65,000)
| ARM
Interest Rate |
Monthly
Payment |
| First
year @ 10% |
570.42 |
| 2nd
year @13% (without
cap) |
$717.12 |
| 2nd
year @ 12% (with
cap) |
$667.30 |
| Difference
in 2nd year between
payment with cap
and payment without
= $49.82 |
A drop in interest rates
does not always lead to
a drop in monthly payments.
In fact, with some ARMs
that have interest rate
caps, your payment amount
may increase even though
the index rate has stayed
the same or declined.
This may happen after
an interest rate cap has
been holding your interest
down below the sum of
the index plus margin.
With some
ARMs, payments
may increase even if the
index
rate stays the same or
declines.
Look below at the example
where there was a periodic
cap of 2% on the ARM,
and the index went up
3% at the first adjustment.
If the index stays the
same in the third year,
your rate would go up
to 13%!
| ARM
Interest Rate |
Monthly
Payment |
| First
year @ 10% |
$570.42 |
| If
index rises 3% ... |
| 2nd
year @12% (with
2% rate cap) |
$667.30 |
| If
the index stays
the same for the
3rd Year |
| 3rd
year @13% |
$716.56 |
| Even
though index stays
the same in the
3rd year, payment
goes up $49.26 |
In general, the rate
on your loan can go up
at any scheduled adjustment
date when the index plus
the margin is higher than
the rate you are paying
before that adjustment.
The next example shows
how a 5% overall rate
cap would affect your
loan:
| ARM
Interest Rate |
Monthly
Payment |
| First
year @ 10% |
$570.42 |
| 10th
year @ 15% (with
cap) |
$813.00 |
Let's say that the index
rate increases 1% in each
of the first ten years.
With a 5% overall cap,
your payment would never
exceed $813.00 - compared
to the $1008.64 that it
would have reached in
the tenth year based on
a 19% indexed rate.
Payment Caps Some
ARMs include payment caps,
which limit your monthly
payment increase at the
time of each adjustment,
usually to a percentage
of the previous payment.
In other words, with a
7-1/2% payment cap, a
payment of $100 could
increase to no more than
$107.50 in the first adjustment
period, and to no more
than $115.56 in the second.
Lets assume that your
rate changes in the first
year by 2 percentage points,
but your payments can
increase by no more than
7-1/2% in any one year.
Here's what your payments
would look like:
| ARM
Interest Rate |
Monthly
Payment |
| First
year @ 10% |
$570.42 |
| 2nd
year @ 12% (without
payment cap) |
$667.30 |
| 2nd
year @ 12% (with
7-1/2% payment cap) |
$613.20 |
| Difference
in monthly payment
= $54.10 |
Many ARMs with payment
caps do not have periodic
interest rate caps.
Negative Amortization
If your ARM contains a
payment cap, be sure to
find out about "negative
amortization". Negative
amortization means the
mortgage balance is increasing.
This occurs when ever
your monthly mortgage
payments are not large
enough to pay all of the
interest due on your mortgage.
Because payment caps
limit only the amount
of payment increases,
and not interest-rate
increases, payments sometimes
do not cover all of the
interest due on your loan.
This means that the interest
shortage in your payment
is automatically added
to your debt, and interest
may be charged on that
amount. You might therefore
owe the lender more later
in the loan term than
you did at the start.
However, an increase in
the value of you home
may make up for the increase
in what you owe.
The next table uses the
figures from the preceding
example to show how negative
amortization works during
one year. Your first 12
payments of $570.42, based
on a 10% interest rate,
paid the balance down
to $64, 638.72 at then
end of the first year.
The rate goes up to 12%
in the second year. But
because of the 7-1/2%
payment cap, payments
are not high enough to
cover all the interest.
The interest shortage
is added to your debt
(with interest on it),
which produces negative
amortization of $420.90
during the second year.
| Beginning
Loan Amount = $65,000 |
| Loan amount @
end of first year
= $64,638.72 |
| Negative amortization
during 2nd year
= $420.90 |
Loan amount @
end of 2nd year
= $65,059.62
($64,638.72 + $420.90) |
| (if you sold your
house at this point,
you would owe almost
$60 more than the
amount you originally
borrowed.) |
To sum up, the payment
cap limits increases in
your monthly payment by
deferring some of the
increase in interest.
Eventually, you will have
to repay the higher remaining
loan balance at the ARM
rate then in effect. When
this happens, there may
be a substantial increase
in your monthly payment.
Some mortgages contain
a cap on negative amortization.
The cap typically limits
the total amount you can
owe to 125% of the original
loan amount. When that
point is reached, monthly
payments may be set to
fully repay the loan over
the remaining term, and
your payment cap may not
apply. You may limit negative
amortization by voluntarily
increasing your monthly
payment.
Be sure to discuss negative
amortization with the
lender to understand how
it will apply to your
loan.
Prepayment and Conversion
If you get an ARM and
your financial circumstances
change, you may decide
that you don't want to
risk any further changes
in the interest rate and
payment amount. When you
are considering an ARM,
ask for information about
prepayment and conversion.
Prepayment. Some
agreements may require
you to pay special fees
or penalties if you pay
off the ARM early. Many
ARMs allow you to pay
the loan in full or in
part without penalty whenever
the rate is adjusted.
Prepayment details are
sometimes negotiable.
If so, you may want to
negotiate for no penalty,
or for as low a penalty
as possible.
Conversion. Your
agreement with the lender
can have a clause that
lets you convert the ARM
to a fixed-rate mortgage
at designated times. When
you convert, the new rate
is generally set at the
current market rate for
fixed-rate mortgages.
The interest rate or
up-front fees may be somewhat
higher for a convertible
ARM. Also, a convertible
ARM may require a special
fee at the time of conversion.
