What are Rate caps?

Posted by  on Apr 21, 2009

Rate caps are features of adjustable rate mortgages. 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 effective for anywhere from a month for a monthly COFI ARM to several years for a hybrid ARM. It is crucial 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.

Caps are important features of Adjustable Rate Mortgages and should be closely scrutinized when selecting a loan. There may be three different caps in fact.

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 loans' 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.

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 caos 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 reasonable expect to pay about 3.75%. Unless your loan has a 4% floor.

Most lending guidelines require that you be qualified either at the fully indexed rate or 2 points over the start rate. However, your rate could conceivably go as high as the life cap, perhaps 6 points over the rate you paid initially and 4 points higher than what the lender determined that you could afford. That's the risk of ARM loans.

So in today's market, ARMs are a viable choice.

For example, one couple interviewed in a CNNMoney.com story explained that they purchased a $500,000 home with an FHA-insured ARM of 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. Liz Freeman has more than a decade of mortgage lending experience. She writes about mortgage
and finance issues
and is a regular contributor to Mortgage News Daily.


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