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Author: Dwdonhoff Big gold star, 5000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 127237  
Subject: Re: ARM rates up? Date: 1/22/2002 10:22 PM
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Hi ACME,

Probably a very basic question, but... Can you explain these? If you had said 2-6, I would have figured that meant the rate cannot rise more than 2% in one year and 6% over the life of the loan...but you have a second 2 in there that I cannot figure out...

I am so sorry! If you had the guts to ask, there were/are dozens of timid Fools lurking who won't ask. I shoulda known better...

First of all, technically, these programs are known as "hybrid ARM loans" because a "traditional ARM" is adjustable right out of the gate. Thus, these are hybrids between fixed rate proggies and traditional ARMS.

The "Hybrid ARM" basic flavors;
1/1
3/1
3/6
5/1
5/6
7/1
10/1

The first number is how long the fixed period is.
The 2nd number, if a "1", is the adjustability (once per year,)
IF the 2nd number is a "6", it adjusts once per 6 months (*bi-annually,)
(*NEVER assume common-sense reasoning in the mortgage biz! ;~)

The adjustability of an ARM is it's MARGIN (a fixed number the lender says is it's prfitability above a certain index value), which is added to an INDEX VALUE (a common financial index published regularly, such as the Treasury Index, LIBOR index, COFI, MTA and COSI indices. (The last 3 being primarily used just in Option ARMs... an entirely different animal.))

The adjustability, in addition to the limits of the index it's tied to, are restrained to absolute maximum upward or downward adjustments per time period. These constraints are known as their "Caps."

Caps primarily come in 2 formats;
2-2-6, and
5-2-5

In a 2-2-6 Cap the loan has a maximum adjustability in it's very first adjustment of 2%, with an annual maximum adjustment of 2%, and a lifetime maximum adjustment from it's initial rate of 6%.

In a 5-2-5 Cap the loan has a maximum adjustability in it's very first adjustment of 5%, with an annual maximum adjustment of 2%, and a lifetime maximum adjustment from it's initial rate of 5%.

Historically, there have actually been very few periods when rates adjusted annually upwards every available period (nor downwards.) Just as in any other free market, adjustability tends to go up and down... but the "Caps" serve as guarantees of shock-absorbers were the economy to completely go in the can.

Of course, they also serve theoretically to protect lenders who lend on ARMs in high rate environments and the rates drop out from under them. I say "theoretically" because the borrower has the freedom to bail out of an ARM when rates drop (as no Foolish borrower would take a voluntary prepay penalty in high interest rates) so lenders never get a break in dropping markets. (poor babies, right ;~)

So... there ya go! Now you know it all... wanta come work with me?

Cheers,
Dave Donhoff
Foolish Mortgage Captain
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