An ARM generally comes with caps on the annual adjustment and over the life of the loan (see below information from the Consumer Financial Protection Bureau). However, they can vary among lenders, which makes it important to fully understand the terms of your loan.
- Initial adjustment cap. This cap says how much the interest rate can increase the first time it adjusts after the fixed-rate period expires. It’s common for this cap to be either 2 percent or 5 percent — meaning that at the first rate change, the new rate can’t be more than 2 (or 5) percentage points higher than the initial rate during the fixed-rate period.
- Subsequent adjustment cap. This clause shows how much the interest rate can increase in the adjustment periods that follow. This number is commonly 2 percent, meaning that the new rate can’t be more than 2 percentage points higher than the previous rate.
- Lifetime adjustment cap. This term means how much the interest rate can increase in total over the life of the loan. This cap is often 5 percent, meaning that the rate can never be 5 percentage points higher than the initial rate. However, some lenders may have a higher cap.
Even if your initial interest rate is palatable, make sure you know the highest payment you could be liable for on your loan if rates rise. A Truth in Lending disclosure, which your lender must give you within three days of your loan application, should include this information, according to the CFPB.
Rinaldi said an ARM might make sense for buyers who anticipate moving before the initial rate period expires. However, because life happens and it’s impossible to predict future economic conditions, it’s wise to consider the possibility that you won’t be able to move or sell.
For homeowners considering an ARM as a refinancing option, the same general considerations apply.
Also, if you already were pushing the bounds of your budget to buy a particular house, you need to evaluate whether your financial situation will improve enough to accommodate a potentially higher rate when the first change hits.
“That adjustment will be here before you know it,” Rinaldi said.