An adjustable rate mortgage holds a fixed rate for an initial period, then adjusts on a schedule for the rest of the term. The uncertainty that creates is bounded, and the bounds are written into the note as three numbers.
Those three numbers are the whole subject of this guide, because they turn an open-ended question about future rates into a closed one about arithmetic.
Reading a 5/1 ARM with 2/2/5 caps
5/1 describes the timing: the rate is fixed for 5 years, then adjusts once every 1 year thereafter.
2/2/5 describes the limits on each move:
| Cap | Meaning |
|---|---|
| Initial (2) | The most the rate can change at the first adjustment |
| Periodic (2) | The most it can change at each adjustment after that |
| Lifetime (5) | The most it can ever be above the starting rate |
The lifetime cap is the one that matters most, because it is the only one that bounds the final answer rather than the speed of getting there.
The worst case, worked through
Take $400,000 at a start rate of 6%, fixed for 60 months, over a 30-year term, with 2/2/5 caps.
The starting payment is the standard amortisation payment at 6% over 360 months:
M = P x i(1 + i)^n / ((1 + i)^n - 1)
giving $2,398.20 a month.
Now walk the caps up:
Months 1-60 6% (the fixed period)
Month 61 8% start + initial cap of 2
Month 73 10% plus periodic cap of 2
Month 85 11% lifetime cap reached: 6 + 5 = 11, so the climb stops
The third adjustment is limited to one point rather than two, because the lifetime cap of five points above the 6% start puts an absolute ceiling at 11%, and it cannot go higher however the index moves.
So the honest statement about this loan is not a prediction. It is this: the payment cannot exceed what 11% produces on the balance remaining at that point, and that figure is computable today.
That is what our ARM calculator reports, and it is why that page deliberately shows no amortisation schedule. Printing a month-by-month table would require committing to one rate path, which would turn a contractual ceiling into a forecast. The ceiling is a fact about your contract. The path is a guess about the economy.
Where the rate actually comes from
At each adjustment, your rate is:
rate = index + margin
The index is a published market rate that moves. The margin is a fixed number of percentage points set in your note, and it never changes.
Then the caps are applied, which is why the index can move more than your rate does. If the index jumps four points at your first reset but your initial cap is two, your rate moves two.
Some notes also carry a floor, below which the rate cannot fall however low the index goes.
What your lender has to tell you
ARM adjustments carry disclosure obligations under Regulation Z. Section 1026.20 covers disclosure requirements regarding post-consummation events, which includes the advance notice before a rate adjusts and the information that notice must contain. The general rule is at 12 CFR 1026.
The practical consequence is that you should not be surprised by an adjustment. You receive notice ahead of it, with the new rate and the new payment.
What is not knowable
Where the index will be in five years. This page does not estimate it, and a calculator that does is producing a number with no basis you can check.
What is knowable is the ceiling, the floor if your note has one, and the payment at every rate between them.
All three are in your closing documents. The note states the caps, the margin and the index it tracks, and you should receive written notice before each adjustment with the new rate and the new payment on it. If you have never read those three figures out of your own paperwork, that is a fifteen-minute job with a larger payoff than any calculator on this site.
Questions
- What do the three numbers in 2/2/5 mean?
- In order: the most the rate can move at the first adjustment, the most it can move at each adjustment after that, and the most it can ever move above the starting rate over the life of the loan. So 2/2/5 means up to two points at the first reset, two points at each later reset, and never more than five points above where you started.
- Is the worst case likely?
- This site takes no view on that, because it would be a forecast about interest rates and nobody can make one reliably. The worst case is worth knowing because it is the figure your contract permits, which makes it the honest boundary on what the payment could become.
- Can the rate go down as well as up?
- Yes, subject to the same caps in reverse and to any floor in your note. The rate is set by an index plus a fixed margin, so if the index falls the rate follows it down until it hits the floor.
- What is the difference between the index and the margin?
- The index is a published market rate that moves. The margin is a fixed number of percentage points your lender adds to it, and it does not change for the life of the loan. Your rate at each reset is the index on the reset date plus the margin, then constrained by the caps.