Economic experts are still talking about a future rise in interest rates. If you have an adjustable rate mortgage (ARM), you could be at risk of rising payments if there is no cap on your loan over time. For example, if the index, which is used to calculate the interest rate on an adjustable-rate mortgage, rose steadily and aggressively every year and there was no limit in place to restrict how high it could go, you could conceivably watch your interest rates rapidly shoot up from 5% to 11% or higher over the course of just a few years. A 5% interest rate is manageable, but an 11% rate over many years could potentially create serious problems for you.
For this reason, most ARMs have interest rate caps in place. Caps place a limit on how high a loan payment can increase over the course of a single adjustment period. The standard cap is roughly 2% every 12 months but this can vary.
Let’s imagine you have an ARM with an interest rate of 3% that has a 3% margin. Several years later when it’s time to reset the rate, the index has risen to 6%. In this scenario, when the margin is added in with the new index rate, the total interest rate would be 9%.
If your loan does not specify capping limits, you would be stuck with a 9% rate, which is a fairly drastic jump from the initial 3% you were accustomed to paying. If, however, the ARM has a cap of 2% for adjustment periods, then the increases and decreases could never fluctuate by more than 2% from one year to the next.
In this case, rather than getting hit with a new rate of 9%, your rate would move to 7%, which is 2% higher than the previous rate.
Caps can also be applied to the lifetime of an ARM.
- For example: Let’s say that your ARM has a lifetime cap of 8%. The rate currently sits at 5%, but one year later the index rises to 6% bringing the fully indexed interest rate, which is the interest rate calculated by adding the margin to an index level, to 9%. Because of the lifetime cap of 8%, your new interest rate would never rise higher than 8%.
Putting It All Together
- An example: You put $30,000 down on a $200,000 home, leaving you with a $170,000 mortgage. You elect a 30-year, 3/1 adjustable rate mortgage and the interest rate is 3% with an annual cap of 2% and a lifetime cap of 12%.
- Based on these numbers, the initial monthly payment for your mortgage will be $717. This will be the monthly payment for the first month and the next 35 months thereafter. (Remember, this is only the mortgage and interest portion of your home payment. There is still property tax, HOA fees, insurance and maintenance fees to consider.)
- After three years pass, the mortgage will be reset based on the index, which your lender uses to determine rates. In this scenario, let’s assume the interest rate will increase by 1%. After this reset, then the monthly payments would increase to $803 per month and the overall year-end increase would total $1,032.
- If after three years, the interest rate increased to 2% instead of the 1% mentioned above, your monthly payments would jump to $895.
Compare the scenarios above to what would happen if the ARM did not have an annual cap in place. Let’s say the loan rate went up by three percentage points.
Without an annual cap on the ARM, you could be stuck with a 3% increase, which would bring the monthly payments to $992. This means that within a single year, your payments could increase by $275 per month, or an overall annual increase of $3,300.
These examples are shown to highlight the very big difference that just one or two percentage points can make when it comes to home interest rates.
While there is the potential for much larger mortgage payments when an ARM loan resets, there is also the potential for big savings if interest rates happen to go down. Take a look at what would happen to the exact same adjustable-rate mortgage if the loan rates went down after the first 36 months of the loan:
- If the newly adjusted rate dropped by half a percentage point to 2.5%, the monthly payments would drop from $717 to $675. If the newly adjusted rate dropped by a full percentage point to 2%, the monthly payments would drop to $636 and annual savings would be $972.
When you’re ready to look at the numbers in more detail for your new home, give me a call at (602) 456-2195. I’d be happy to walk you through all the possible scenarios so you can make the best decision for your future.
Source: Salted Stone
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