Adjustable Rate Mortgage Rate Cap With a rate cap, even if the index rises, increases in the rate and monthly payment are limited. Suppose your interest rate is tied to the Bank Board index. Your mortgage limits rate changes to one per year, although it doesn't limit the amount of the change. For example, assume your starting interest rate is 11% on September 1, 1986. Based on these terms, if the Bank Board index rises 2 percentage points by September 1, 1987, your new rate for the next year will be 13%. Rate Caps To build predictability into your adjustable rate loan, some lenders include provisions for "rate caps" that limit the amount your interest rate may change. These provisions limit the amount of your risk. A periodic rate cap limits the amount the rate can increase at any one time. For example, your mortgage could provide that even if the index increases 2 % in one year, your rate can only go up 1%. An aggregate rate cap limits the amount the rate can increase over the entire life of the loan. This means that, for example, even if the index increases 2 % every year, your rate cannot increase more than 5 % over the entire loan. Many flexible rate mortgages offer the possibility of rates that may go down as well as up. In some loans, if the rate can only increase 5 %, it may only decrease 5 %. If no limit is placed on how high the rate can go, there may be a provision that also allows your rate to go down along with the index. Because they limit the lender's return, capped rates may not be available through every lender.

Payment Caps If the interest rate on your adjustable rate loan increases and your loan has a payment cap, your monthly payments may not rise, or they may increase by less than changes in the index would require. For example, assume your mortgage provides for unlimited changes in your interest rate but your loan has a $50 per year cap on payment increases. You started with a 11% rate on your $75,000 mortgage and a monthly payment of $714.24. Now assume that your index increases 2 percentage points in the first year of your loan. Because of this, your rate increases to 13 %, and your payments in the second year two should rise to $828.33. Because of the payment cap, however, you'll only pay $764.24 per month in the second year. If the index increases, so does the interest rate. However, monthly payment changes are limited (although the total amount owed may increase). But remember: if your payment capped loan results in monthly payments that are lower than your interest rate would require, you still owe the difference. Negative ammortization may take place to ensure that the lender eventually receives the full amount. In most payment-capped mortgages, the amount of principal paid off changes when interest rates fluctuate. Suppose you are paying $650 a month with $500 going toward interest, with your rate at 12%. Then your rate increases to 13%. This means your monthly payment should increase to $697.39, but because of a cap, it increases to only $675. Because this change in interest rates increases your debt, the lender may now apply a larger portion of your payment to interest. If rates get very high, even the full amount of your monthly payment ($675) won't be enough to cover the interest owed; the additional amount of interest you owe will be added to the principal. This means you now owe--and eventually will pay--interest on interest.

Variations One variation of the adjustable rate mortgage is to fix the interest rate for a period of time -- 3 to 5 years, for example -- with the understanding that the interest rate will then be renegotiated. Loans with periodically renegotiated rates are also called rollover mortgages. Such loans make monthly payments more predictable because the interest rate is fixed for a longer time. Another variation is the pledged account buy-down mortgage with an adjustable rate. This plan was introduced by the Federal National Mortgage Association (Fannie Mae), which buys mortgages from lenders and provides a major source of money for future mortgage offerings. In this plan, a large initial payment is made to the lender at the time the loan is made. The payment can be made by the buyer, the builder, or anyone else willing to subsidize the loan. The payment is placed in an account with the lender where it earns interest. This plan helps lower your interest rate for the first year. This plan could lower your rate, for example, by 4% in the first year. If you borrowed $50,000 at 13%, for example, this would reduce your rate to 9% and your monthly payments to $402.31, a savings of approximately $151 monthly. Then, for the next 5 years, your interest rate would only increase, for example, by I point each year. After that, your mortgage becomes an adjustable rate mortgage with interest rate and payment changes based upon an index. This plan may not include any payment or rate caps other than those in the first years. But, there also may not be negative amortization, so possible increases in your total debt may be limited. Because of the buy-down feature, some buyers may be able to qualify for this loan who otherwise would not be eligible for financing.

Summary In shopping for any type of adjustable rate loan, remember to look for the following: the initial interest rate; how often the rate may change; how much the rate may change; the initial monthly payments; how often payments may change; how much the payments may change; the mortgage term; how often the term may change; how much the term may change; the index that rate, payment, or term changes are tied to; and, the limits, if any, on negative amortization. © Copyright Federal Trade Commission 6th & Pennsylvania Avenue, N.W. Washington, DC 20580 (202) 326-2222 <-- PREVIOUS PAGE | NEXT PAGE -->