MCP Help Blog

Who’d have thought? Today, lenders are putting limits on how LOW an adjustable rate mortgage rate can go. Just like caps on interest rate adjustments help protect borrowers, interest rate floors protect lenders. Rate caps are features of all adjustable rate mortgages. When buying a new home or refinancing with an ARM loan, you paid careful attention to these caps (because you read this blog!). Rate caps drive your interest rates just as surely as the financial index does.

Over the life of an ARM, you may pay several different rates. The start rate is usually a below-market rate, sometimes called a teaser. This rate may be in effect for anywhere from a month for a monthly COFI ARM to several years for a hybrid ARM. It is critical for homeowners to know when their rates will reset and what they will be paying when that happens–and that’s where rate caps come in.

You might have three different rate caps to worry about. First, there is the periodic cap, which determines the highest rate to which your ARM could increase in a single adjustment. If your current rate is 3% and your cap is 1%, your rate can only go to 4% this time. If you have a hybrid ARM, one that is fixed for a few years before it converts to an ARM, there may be a higher cap on the first adjustment, say 3%. This limits how high your rate can go the very first time it adjusts. The life cap is the highest rate you can be charged over the life of the loan, typically 5 to 7 points over your start rate.

In addition to caps, you should also consider a loan’s floors.
These are limits to how LOW your rate can go at a single adjustment or over its life. Right now, many indexes used to calculate ARM rates are very low, even near zero. But if your loan has a floor of 4%, that’s a low as your rate will go. So that’s another consideration that most people probably paid little  attention to in the past.

Your rate is determined by three components–an index, a margin, and applicable caps or floors.
The index is an external rate that reflects the conditions of money markets in general. According to the Federal Reserve, the most common indices are the 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).

The margin is a percentage that the lender adds to the index and is usually between 2 and 5 percent.The sum of the index and the margin is the actual rate you pay (subject to caps and floors). This is called the fully-indexed rate. So, if you have an ARM based on the 6-month LIBOR index with a 2 percent margin and you are due for an adjustment or reset in early 2009, you could reasonably expect to pay about 3.75%. Unless your loan has a 4% floor.

So in today’s market, ARMs are a viable choice. For example, a family interviewed in a CNNMoney.com story explained that they bought a $500,000 home with an FHA-insured ARM at just 3.875% for the first five years. After that, it resets once a year and cannot go up by more than one percentage point annually. It has a five point lifetime cap, so the rate can never exceed 8.875%. They figured that the initial savings would keep them on the winning side of that equation for at least 12 years.

The key is to enlist the help of an experienced loan agent, play around with mortgage calculators and look at different loan scenerios, know your time frame, and consider rate caps and floors when comparing mortgages.