Question

A borrower takes out a 7/1 ARM with 2/1/6 caps and a start rate of 3.5%. The margin is 4% and the loan is for $200,000 on a 30-year term. The index is based on the LIBOR.If at the 1st adjustment period the current LIBOR is at 5%. What will the rate adjust to for this borrower's loan?

A. 3.5%
B. 5.6%
C. 3.2%
D. 7.5%

Answer 1

The borrower's new interest rate would adjust to 5.5%, which is the original rate of 3.5% plus the maximum allowed increase of 2% given the first cap on the 7/1 ARM loan.

Step-by-step explanation:

An adjustable-rate mortgage (ARM) is a type of loan that can be used to purchase a home, and its interest rate can vary alongside the rate of inflation. In the scenario provided, a borrower has a 7/1 ARM with 2/1/6 caps, a start rate of 3.5%, and a margin of 4%. The first adjustment occurs after 7 years, and subsequent adjustments can happen annually. When it's time for the interest rate adjustment, we calculate the new rate by combining the current index rate with the margin, as long as it remains within the caps established.

Given that the current LIBOR index is at 5%, the borrower's new interest rate would be calculated as follows: LIBOR + margin = 5% + 4% = 9%. However, because of the first cap of 2%, the interest rate can only increase to a maximum of 5.5% for this initial adjustment period (starting rate of 3.5% plus the 2% cap).

Due to the 2% initial cap, the new interest rate will adjust to the maximum allowed 5.5% from the original 3.5%, even though the LIBOR plus margin would result in a higher rate. Thus, the correct answer is B. 5.5%.