A 5/1 ARM starts at a fully indexed rate of 4.25%, consisting of a 1.50% index plus a 2.75-percentage-point margin. It has a 2-percentage-point initial adjustment cap and a 5-percentage-point lifetime cap. At the first adjustment, the index is 3.90%. What is the new interest rate after applying the initial adjustment cap?
Correct Answer
A) 6.25%, because the 2% initial cap holds the rise below the fully indexed rate.
Two numbers compete and the smaller one wins. The fully indexed rate would be 4.25 plus 2.4, which is 6.65%, but the initial adjustment cap allows only 2 points of movement, taking the rate to 6.25%. Other choices: 6.65% is what the index would give if no cap applied, and the lifetime cap is not what binds here; 7.00% adds the margin a second time, when the margin is already inside the start rate; and the initial cap limits an adjustment rather than preventing one. Source: Adjustment caps as disclosed on the note; no statutory figure is asserted
Why This Is the Correct Answer
Two numbers compete and the smaller one wins. The fully indexed rate would be 4.25 plus 2.4, which is 6.65%, but the initial adjustment cap allows only 2 points of movement, taking the rate to 6.25%. Other choices: 6.65% is what the index would give if no cap applied, and the lifetime cap is not what binds here; 7.00% adds the margin a second time, when the margin is already inside the start rate; and the initial cap limits an adjustment rather than preventing one. Source: Adjustment caps as disclosed on the note; no statutory figure is asserted
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