Question

If the initial contract rate on an ARM is 6%, the second year contract rate is 9%, the margin is 2%, the life of the loan cap is 5%, and the annual cap is 3%, what is the contract rate for year three if the index is 9%? 13%, 12%, 8%, 11%? <options

Answer 1

Initial Contract Rate = 6%

Second Year Contract Rate = Index+Margin = 9%
Since Margin = 2%,
?2nd year Index = 7%

3rd year Index = 9%
?3rd year contract rate = 3rd year Index(given to be 9%) + Margin
? = 9%+2%
   =11%
?The 3rd year contract rate (11%) is within 3% of 2nd year contract rate. Thus, it satisfies the criteria of the annual cap of 3%. Annual cap means the interest rate sould not increase beyond the cap from one year to another.

?Second check: Life of loan cap of 5%
?This means, the contract rate over the life of loan should never exceed 5% of the intitial rate at year 1
?Contract rate at year 1 : 6% (given)
?Contract rate at year 3: 11% (calculated) - Contract rate at year 3 satisfies the criteria of life of loan cap