ARM caps are contractual limits on how much the interest rate can change. Every standard ARM has three caps: an initial cap, a periodic cap, and a lifetime cap. These are expressed as a set of three numbers such as 5/2/5 or 2/1/5. Borrowers who do not understand caps will be unprepared for worst-case rate scenarios.
The Three Cap Numbers
- ✦Initial cap: maximum rate increase at the first adjustment (a 5% cap means the rate can jump by at most 5% at year 6 on a 5/1 ARM)
- ✦Periodic cap: maximum rate change at each subsequent annual adjustment after the first (e.g., 2% per year)
- ✦Lifetime cap: maximum total rate change over the life of the loan from the original note rate (e.g., 5% total ever)
5/2/5 vs. 2/1/5 Cap Structures
The 5/2/5 cap is the most common structure on 5/1 ARMs. At first adjustment, the rate can move up to 5%. Each year after, up to 2%. Total lifetime movement cannot exceed 5%. The 2/1/5 structure is more common on ARMs with shorter initial periods. The initial cap of 2% is gentler at first adjustment but the same lifetime ceiling applies.
Calculating Worst-Case Payment
Always show borrowers the worst-case payment. Take the note rate, add the lifetime cap (e.g., 5%), and calculate the monthly payment on that fully capped rate. If the borrower cannot afford that payment, they are in the wrong product. Regulation Z requires the Loan Estimate to disclose maximum possible payment, but running the scenario in your conversation builds trust and prevents future complaints.
Aria can generate worst-case ARM payment scenarios for any note rate, loan amount, and cap structure in seconds. Ask at vicariointel.com.
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