Business Glossary

clause in an adjustable-rate mortgage (ARM) limiting any increase in the interest rate during a calendar year adjustment period to a preset amount or ceiling, giving the borrower a cushion against a sudden increase in mortgage payments and payment shock when the loan rate is adjusted, particularly in periods of rising interest rates. A 10% mortgage with a 2% annual cap will increase only to 12% even if the mortgage indent rate goes up by 3%.

clause in an adjustable-rate mortgage (ARM) limiting monthly payment adjustments, usually restricting the increase to a percentage of the previous payment. An ARM with a 71/2% payment cap and monthly payments of $100 can increase to no more than $107.50 in the first adjustment period, and $115.56 in the second.

residential mortgage in which the interest rate floats up or down according to changes in an index rate. Adjustable-rate mortgages usually have lower initial interest rates than fixed-rate mortgages, so there is an opportunity for substantial interest savings over the life of the loan if rates remain steady or decline. Adjustable-rate mortgages first appeared in the 1960s but did not gain wide popularity until the 1980s, when lenders began promoting ARM loans as a low-cost alternative to thirty-year, fixed-rate mortgage loans. ARMs are structured with built-in limits, called interest-rate caps, to cushion the impact of interest-rate fluctuations on loan payments in any year or over the life of the loan. An adjustablerate mortgage with an initial rate of 41/2%, an annual cap of 1%, and a lifetime cap of 4% will have an interest rate no higher than 91/2%. ARM rates are usually adjusted every six months or once a year, depending on the type of loan. Loan payment caps do not limit the amount of interest the lender is earning, which means an ATM loan may cause negative amortization if the accrued loan interest exceeds the interest actually paid.

When computing the loan interest rate, the lender adds a margin to an index rate selected as the benchmark, or base rate. The most common indexes are the Constant Maturity Treasury (CMT) index of Treasury issues with the same final maturity; the Treasury Bill index,based on the current auction yield of 3-month, 6-month or 1-year Treasury bills; the 12-month Moving Treasury Average, computed from the Treasury CMT index for the previous 12 months; the 11th District Cost of Funds Index, the weighted average cost of savings accounts, Federal Home Loan Bank advances, and other sources of funds paid by savings institutions in the 11th Federal Home Loan Bank district; the London Interbank Offered Rate (LIBOR), the rate major London banks charge each other for borrowings; the certificate of deposit (CD) index, the average rate earned by nationally traded certificates of deposit; and the bank prime rate, the rate banks charge their prime business borrowers. The most popular are the Treasury indexes, the 11th District Cost of Funds Index, and the LIBOR index. A popular variation of the adjustable-rate mortgage is the HYBRID ARM, in which the loan has a fixed interest rate for 3 to 10 years and thereafter adjusts according to market conditions.