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Hong KongARM caps and indexes
The rate on an adjustable-rate mortgage is the index plus the margin, limited by an initial cap, a periodic cap and a lifetime cap. A 2/2/5 structure means two, two and five percentage points.
Adjustable-rate questions are arithmetic questions in disguise. Get the mechanism and they become easy marks.
The formula
Fully indexed rate equals index plus margin.
The index moves with the market and the lender does not control it. The margin is fixed for the life of the loan and is the lender's. Add them and you have the rate the loan wants to charge. Apply the cap last.
Then the caps limit it
| Cap | What it limits |
|---|---|
| Initial | How much the rate can move at the first adjustment |
| Periodic | How much at each subsequent adjustment |
| Lifetime | How far the rate can ever move from the start rate |
A 2/2/5 structure means two percentage points at first adjustment, two at each one after, and five over the life of the loan.
A worked example
Start rate 4 percent, 2/2/5 caps, index at first adjustment 5 percent, margin 3 percent.
Fully indexed rate is 8 percent. But the initial cap allows only 2 points of movement, so the rate goes to 6 percent, not 8.
Questions are built so the fully indexed rate exceeds the cap. Candidates who calculate index plus margin and stop have found the distractor. Always apply the cap afterwards.
Hybrids
A 5/1 ARM is fixed for five years then adjusts annually. The first number is the fixed period in years and the second is the adjustment frequency.
Do not confuse the 5/1 notation with the 2/2/5 cap notation. They describe different things and appear in the same question.
Common questions
How is an ARM rate calculated?
Index plus margin, then limited by the initial, periodic and lifetime caps.
What does 2/2/5 mean?
Two percentage points at the first adjustment, two at each subsequent one, and five over the life of the loan.
What does 5/1 mean?
Fixed for five years, then adjusting annually.
Which part of the rate does the lender control?
The margin, which is fixed for the life of the loan. The index moves with the market.
What is the commonest ARM mistake on the exam?
Calculating index plus margin and forgetting to apply the cap, which is exactly what the distractor offers.