10 must-know ARM, reset terms
Adjustable rate mortgages can be tricky beasts with a language of their own, so learn your cap, index and reset terms. Here are 10 of the most important terms.
10 must-know ARM, reset terms
1. Cap. The top limit on the amount the interest rate can increase during a certain period of an adjustable-rate mortgage, or ARM.
Every ARM has two caps: a periodic cap, which limits the periodic changes to the interest allowed in the loan agreement, and a lifetime cap, which governs the total increase that can be imposed during the life of the loan.
2. Cap -- lifetime. The lifetime cap is the highest possible interest rate that a particular adjustable-rate mortgage, or ARM, can have. Many ARMs have a lifetime cap of 6 percentage points above the introductory rate.
That means, for example, that if the ARM's introductory rate was 5 percent, the maximum possible rate would be 11 percent.
Although the most common lifetime cap is 6 percentage points above the introductory rate, some loans have caps that are greater or less than that.
3. Cap -- periodic. The periodic cap is the limit on the amount that the interest rate can increase or decrease when the adjustment is made on an adjustable-rate mortgage, or ARM.
Many ARMs have a periodic cap that prevents the interest rate from rising or falling more than 2 percentage points in one year.
There are exceptions: On many ARMs that have an introductory rate lasting three or more years, the first rate adjustment is more than 2 percentage points.
4. Index. A table of yields or interest rates being paid on debt (such as Treasury notes or bank deposits) that is used to determine interest-rate changes for adjustable-rate mortgages and other variable rate loans such as credit card debt.
Some of the most common indices are: the one-year Treasury Constant Maturity Yield; the Federal Home Loan Bank (FHL
11th District Cost of Funds; prime rate as listed in the Wall Street Journal.
5. Introductory rate. Often called a teaser rate. The low rate charged by a lender for an initial period.
After the introductory period is over, the rate charged increases to the indexed rate or the stated interest rate.
6. Margin. Expressed as percentage points, the amount that a lender adds to an index to arrive at the final interest rate.
For example, if the index is 9 percent and the margin 2.75 percent, the final interest rate is 11.75 percent.
7. Rate adjustment. The act, by a lender, of changing the rate charged on an adjustable-rate loan.
The loan contract specifies when the rate adjustment is made. The new rate is the combination of the index and a margin, subject to a periodic cap.
8. Reset. When an adjustable mortgage adjusts, its interest rate -- and the payment that the homeowner makes -- is reset.
The first reset in a rising interest rate environment can often be large, causing the homeowner's monthly payment to jump sharply.
9. Recast. In negative-amortizing mortgages (such as pay-option ARMs), the process of adjusting the monthly payments so the balance will be fully repaid over a specified period.
A typical pay-option ARM is recast on its fifth anniversary. At that point, the monthly payments rise so that the mortgage will be paid off in 25 years (30 years after the loan was taken out).
Pay-option ARMs are recast automatically if the loan balance exceeds a limit, often 110 percent of the original loan amount.
For example, if a homeowner borrowed $100,000 in a pay-option ARM and made minimum payments for several years, the loan balance would grow every month until it hit the recast trigger of $110,000.
At that point, the monthly payments would increase so that the loan would be paid off on its 30-year anniversary.
10. Recast trigger. In negative-amortizing mortgages (such as pay-option ARMs), an event that causes the monthly payments to fully amortize the loan.
A typical pay-option ARM has two recast triggers -- one based on time, and the other based on the loan balance. Most pay-option ARMs recast upon the loan's fifth anniversary.
At that point, the monthly payments rise so that the mortgage will be paid off in 25 years (30 years after the loan was taken out).
Pay-option ARMs also automatically recast if the loan balance exceeds a limit, often 110 percent of the original loan amount.
For example, if a homeowner borrowed $500,000 in a pay-option ARM and made minimum payments for several years, the loan balance would grow every month until it hit the recast trigger of $550,000.
At that point, the monthly payments would increase so that the loan would be paid off on its 30-year anniversary.
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