Adjustable rate mortgages

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Adjustable Rate Mortgages

Our next term to master is caps (or ceilings). A cap is the maximum amount by which the composite rate can increase on any reset date. Caps provide protection for borrowers against big changes in the monthly payment amount, but reduce the amount of interest rate risk being shifted from the borrower to the lender. ARM loans without caps can lead to payment shock for borrowers if index rates increase dramatically as of a reset date. Most ARM loans have two caps: one that limits the increase in the composite rate on a reset date over the previous composite rate and one that limits the increase in the composite rate on a reset date over the initial composite rate at loan origination. These two caps are commonly called annual (or periodic) caps and lifetime caps. (Quick Thinking Question: Would you expect the margin to be larger or smaller for ARM loans that have caps? Explain your response.)

Reference no: EM132645599

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