Demystifying Adjustable-Rate Mortgages

(MoneyWatch)  Dear Ali;
I'm applying for an adjustable rate mortgage, and I was told that "the caps are 5/2/5." What does that mean?
A: Welcome to the wonderful world of adjustable-rate mortgages! Despite some scary things you may have read, ARMs, as they are known, aren't bad for everyone. (I wrote a marketing piece about this once for Citibank, but my money's where my mouth is: I have two.)

However, as with any loan, you do need to understand the terms on which you're borrowing. The easy part is that an ARM has a set number of years for which it's fixed and then a frequency with which it resets: A "5/1" is fixed for 5 years, and then resets every year after that; a "7/1" is fixed for 7 years, and then resets -- you've got it -- every year.

The tougher thing is to understand what the limits on the resets are. Most ARMs, contrary to popular portrayal, can't reset immediately from zero to 60 -- they work within limits or "caps." That's what those three numbers are.

The first number is the "initial cap." In your example it's 5, so the first year your loan resets, it can increase by no more than five points. If your initial rate is at 4 3/4, say, even if interest rates go up to 15 percent, the max reset that you could face for year six is (4 3/4 + 5) = 9 3/4.

How, you say, are "interest rates" defined? Well, you should ask your banker that. Usually they're priced off a popular index, such as "LIBOR" -- the London Interbank Offered Rate.

The second number is the "periodic cap" -- it's how much rates can jump each time after the first reset. Let's say the first time the loan reset, interest rates weren't at 15 percent, but they were instead at 7 percent. The bank would take the interest rate to market, so it would jump from 4 3/4s to 7 -- a rise of 2 1/4 percent.

The "periodic cap" of 2, the middle number in our example, means that the next possible rise is limited to 2 percent. So if rates THEN go to 15 percent, the bank's next reset is still limited to 7 percent plus 2 percent -- or 9 percent.

The third number is the "lifetime cap" -- it's how much interest rates can rise over the life of the loan. In the example you give it's 5, so your rate could never go above (4 3/4 + 5) = 9 3/4.

You can see from all this that of course we hope rates never rise, but if they do rise we hope we get a low initial reset in year six!