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Because ARM loans are tied to the economy, they can be subjected to significant interest rate changes over the life of the loan. For this reason, the Truth in Lending Law requires that all adjustable rate mortgages have "life caps". A life cap is the maximum rate of interest that can be charged for a particular ARM loan. Every ARM loan must have a life cap that is determined when the loan is made. A life cap can be expressed in terms of a maximum amount of charge from the initial interest rate, such as 6.00% above the initial interest rate. In this instance, using our earlier example, the maximum rate would be 12.13% (6.00% added to the initial interest rate of 6.13%).
In addition to life caps, some ARM loans may have another type of cap, known as an "adjustment cap". This cap is a limit on the amount the interest rate can change at any one time. The frequency with which adjustments can occur will be determined when the loan is made. A common adjustment cap is 2.00%, although a different percentage amount may be used. Using our example of 6.13%, if the maximum amount the interest rate could change at the first adjustment is 2.00%, then the interest rate could go no higher than 8.13%, or no lower than 4.13%, even if the index were to change by more than 2.00%. The idea behind adjustments to caps is to minimize the financial impact of adjustments to a loan.
There are other ARM loans which are capped in a different way. These have "payment caps" in addition to the life cap. This is a limit on the amount that a payment may change at each adjustment. This type of cap is often expressed in terms of a percentage that the amount of a payment may change, such as 5.00%, the most it could increase would be by $50.00. At the next adjustment, the most it could increase would be $52.50 (5.00% of $1,050.00). If your ARM contains a payment cap, be sure to ask about the possibility of "negative amortization". This occurs whenever your monthly mortgage payment is not large enough to pay all of the interest accruing faster than the payment can pay it off, this interest is added back to the principal, causing you to actually owe more at the end of the loan.
As you can see, there are advantages and disadvantages to ARM loans. One of the advantages is that ARM loans are generally offered at lower initial interest rates than fixed-rate loans. Another advantage is the potential for the interest rate to decline over the life of the loan, saving you money. One disadvantage, however, is that the rate may increase over the life of the loan, which would mean that you would end up paying more.
While ARM loans can be fairly complex, federal law requires that you receive a detailed disclosure for any ARM loan program in which you express interest before you make any decisions. This disclosure will list how the loan may adjust over the course of its term. It will allow you to see worst case scenarios of what could happen to your loan payments. Along with the disclosure, you will receive further information which will explain ARM loans in much greater detail. Your loan officer will consult with you and help you to understand all of the different facts and figures and what they represent as a part of the loan. This will help to guide you in your decision process.
As loan officers, we are happy to assist you. The final decision is yours. Be sure to weigh the benefits against the risk and don't be afraid to ask us questions. You may decide that an ARM loan is right for you.
Buying a home is one of he most significant investments you will make in your lifetime, but obtaining a mortgage loan can be a very complicated process. It is important for you to understand all of the costs and information being presented to you when you are shopping for a mortgage loan.