Question

You are given that the teaser rate on a 1/1 ARM is 2.50%. The mortgage has a margin of 2% above 1-year CMT, subject to a rate cap 5/2/5. Answer the following questions:

(i) What is the maximum rate the mortgage can reset to on its first reset date?

(ii) The CMT is 2% at the time of the first reset and at the time of the second reset it goes to 3.5%. What would the rate reset to for the third year? (*Please not that the first reset rate applies to the second year payments and the second reset rate applies to the third year payments.)

Answer 1

In a 5/2/5 ARM, First reset cap is 5%, subsequent annual cap is 2% and Lifetime cap is 5%

Part (i):

Given, initial rate= 2.5%

The maximum rate the mortgage can reset to on its first reset date is initial rate + 5% = 7.5%

Part (ii):

Index= 1-year MCT rate and margin= 2%

Second year rate (first reset) is minimum of the following :

(a ) Applicable index rate of 2% + margin 2% = 4%

(b ) Initial rate + first reset cap of 5%= 2.5% + 5% = 7.5%

(c ) Initial rate + lifetime cap= 2.5% + 5% = 7.5%

Therefore, 2^nd year rate= 4%

Rate reset to the third year is the minimum of the following:

(a ): Applicable 1-year MCT (given as 3.5%) + Margin of 2% = 5.5%

(b): Second year rate + annual cap of 2%.= 4% + 2% = 6%

(c ) Initial rate + lifetime cap= 2.5% + 5% = 7.5%

Therefore, 3^rd year rate= 5.5%