ARM Calculations Questions & Answers
Worst-case Scenario
Prospective borrowers will ask you to calculate the maximum amount that an interest rate on an ARM could rise in a given time period. To perform the calculation, the following must be evident:
The starting interest rate
The first adjustme...
ARM Calculations Questions & Answers
Worst-case Scenario - answer Prospective borrowers will ask you to calculate the
maximum amount that an interest rate on an ARM could rise in a given time period. To
perform the calculation, the following must be evident:
The starting interest rate
The first adjustment date
The frequency of adjustments thereafter
The periodic rate cap
The lifetime rate cap
The time frame of interest
**Licensing exam questions will often provide the index and margin, but they are not
needed for a worst-case calculation.Assume that the rate will rise the most it can for
each adjustment period. The start rate and caps, not the index and margin, control this**
To calculate the rate in the fifth year, follow these steps: - answer {Number of
Adjustments} × {Periodic Cap} = {Periodic Adjustment}
{Start Rate} + {Periodic Adjustment} = {New Rate}
Last Step - answer The last step is to compare the new rate with the maximum rate.
If the new rate is lower than the maximum rate, then the new rate is the correct answer.
If it exceeds the maximum rate, then the maximum rate is the correct answer.
Sample Rate Calculations - answer John and Mary Smith are borrowing $280,000
toward the purchase of a home. The loan is a 3-1 ARM with a start rate of 5.625%, a
periodic rate cap of 2% thereafter, and a lifetime rate cap of 6%. What is the highest
interest rate that could be charged in the fifth year of the mortgage?
Step 2: Adjustment Periods - answer In a 3-1 ARM, the first adjustment occurs at the
end of the third year and applies to the fourth year. The rate adjusts each year
thereafter. In this example, the rate would have adjusted twice, once after the third year
and once after the fourth year.
Step 3: Maximum Rate for Adjustment Period - answer 2 × 2% = 4% (Maximum
Periodic Adjustment)
5.625% + 4% = 9.625% (New Rate for 5th Year)
Step 4: Comparison with Maximum Rate - answer 9.625% < 11.625%
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