Getting Your Cap Straight

Written by Posted On Thursday, 05 August 2021 00:00

As interest rates slowly begin to rise it’s almost inevitable borrowers might consider choosing an adjustable rate mortgage, or an ARM. ARMs will have slightly lower start rates compared to their fixed rate counterparts. Most ARMs today are offered in a ‘hybrid’ version, so-called because they mimic both a fixed rate and an adjustable one, in the beginning at least. 

Such hybrids might be fixed for five years before turning into a loan where the rate can adjust once very year or every six months. This type of mortgage is designated with a 5/1 brand. 7/1 and 10/1 programs are also typically available.  Hybrids can also be a better choice if the home buyers plan on owning the home for just a few years. For someone planning on owning for less than seven years, the 7/1 might be the better choice. 

Okay, so what happens at the end of 5, 7 or 10 years with these programs? After the initial fixed rate period, the loan turns into a rate that adjusts once per year. You might also find 5/6 programs where the rate is fixed for five years then can adjust every six months, although these are not as common. How do they adjust once the initial period has expired? With an index, margin and caps. 

A common index might be the Constant Maturity Treasury, or CMT. If after five years, the associated CMT sits at 0.05% and the margin is 2.00, the new rate would then be 0.05 + 2.00, or 2.05%. The rate will remain there until time for the next adjustment, and the calculation starts all over again in the same manner. But what if the CMT suddenly jumps over the next six months and the new reading is 5.00%?

Using the same formula, the new rate would then be 7.00%. That's quite a jump for someone who’s been enjoying a rate in the low 2.00% range for the past 5 or 7 years. So much so that it could then be unaffordable, even to the point of going into default. To guard against such a scenario, mortgage loan programs employ interest rate caps, or simply ‘caps.’ A cap might have a 1.00% limit on how much the new rate can change at the next adjustment period. That will help ease the pain of a higher payment. Even if the CMA hit 10, the new rate could not be higher than 1.00% above the previous rate.

And speaking of an index around 10, there are also limits on how high the rate can ever be. These are referred to as ‘lifetime’ caps. Many such programs have a lifetime cap of 5.00. Again, these limits keep a lid on interest rates should rates overall begin to rise. 

All of these programs will have such limits. It’s a protection program for both the borrower as well as the lender, allowing for lower initial rates and thus lower payments while at the same time being able to adjust the new rate and payment over the life of the loan. Hybrids can increase affordability while at the same time protecting the borrowers from wild rate swings.

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