A drop in interest rates does not always lead to a drop in monthly payments. In fact, with some ARMs that have interest-rate caps, your payment amount may increase even though the index rate has stayed the same or declined. This may happen when an interest-rate cap has been holding your interest rate down below the sum of the index plus margin. If a rate cap holds down your interest rate, increases to the index that were not imposed because of the cap may carry over to future rate adjustments.
The following example shows how carryovers work.
The index increased 3% during the first year. Because this ARM
limits rate increases to 2% at any one time, the rate is adjusted
by only 2%, to 12% for the second year. However, the remaining
1% increase in the index carries over to the next time the lender
can adjust rates. So when the lender adjusts the interest rate
for the third year, the rate increases 1%, to 13%, even though
there is no change in the index during the second year.
In general, the rate on your loan can go up at any scheduled adjustment date when the lender's standard ARM rate (the index plus the margin) is higher than the rate you are paying before that adjustment.
The next example shows how a 5% overall rate cap would affect your loan.
Let us say that the index rate increases 1% in each of the next nine years. With a 5% overall cap, your payment would never exceed $813.00 -- compared to the $1,008.64 that it would have reached in the tenth year based on a 19% interest rate.
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