How do rate caps on an adjustable rate mortgage work and what is the difference between initial, periodic and lifetime caps?
Here's how adjustable rate mortgages work. The rate the borrower starts out with is called the "start rate." It is fixed for a given period of time, ranging from one month to ten years. For the purpose of this illustration, let's talk about a 3/1 ARM.
The 3/1 ARM is fixed for three years and adjusts at the end of three years and every year thereafter. A typical rate cap structure for a 3/1 ARM is 2/2/6. The initial adjustment cap is 2%, the periodic adjustment cap is 2% and the lifetime cap is 6%.
Let's say that you have a 3/1 ARM with an initial rate of 4% and a 2/2/6 rate cap structure. For three years your rate would be 4%. Because the initial adjustment cap is 2%, for your 4th year, your rate could go up to as much as 6% (4% initial rate plus 2% adjustment cap equals 6%). This does not mean that the rate will go up to 6% -- it might stay the same or even go down. After the fourth year and every year thereafter, the rate could go up as much as 2% (the periodic cap). However, because the lifetime cap is 6%, the rate could never go over 10% (4% initial rate plus 6% lifetime cap equals 10%). Again, this doesn't mean that the rate will go up to 10%, only that it can.
Whether or not it will depends on the index that the rate is tied to and the margin over the index described in the mortgage note. Let's say you have a home equity line of credit where your rate is tied to the prime rate. It might be prime plus 1% for example. In that case the index is the prime rate and the margin is 1%. Thus, if the prime rate is 5%, your rate would be 6%.
Hope this helps.