Adjustment period

Key Takeaways

• An adjustment period has two parts: how long the starting rate is held, and how often the rate may reset after that.
• In a 5/1 ARM the 5 is the number of years before the first change and the 1 is the reset interval, so the rate moves once every twelve months after year five.
• The adjustment period controls when a rate change may happen. A rate cap controls how large that change may be.
• Washington's Mortgage Broker Practices Act, RCW 19.146.030, requires a variable rate loan's increase terms to be disclosed to the borrower in writing within three business days of the loan application.

What It Means

The adjustment period on a variable rate loan is the clock that governs the interest rate. It answers two separate questions: how long the opening rate stays put, and how often the rate may move once that opening stretch ends. Lenders usually state both numbers at once. A 5/1 loan holds the starting rate for five years, then resets it every twelve months for the rest of the Term Of The Loan. A 3/6 loan holds for three years, then resets every six months.

At each adjustment the lender rebuilds the rate out of two pieces: a published Index that moves with the market, plus a fixed Margin the lender adds on top. A borrower does not negotiate the index. A borrower negotiates the margin, the caps, and the length of the opening stretch. A longer opening stretch usually costs more in starting rate, because the lender carries rate risk for longer before it can reprice. None of this should be a surprise at the first reset, since the schedule and the limits belong in the note the borrower signs. Buyers weighing a variable rate against a Fixed Rate Mortgage should look at where rates sit and where they might go, which is the subject of this guide to interest rates and Washington home sales.

How It Works in Washington

Washington does not set the adjustment period itself. Market pricing and federal underwriting rules do that. What Washington regulates is whether the borrower is told. Under RCW 19.146.030, a mortgage broker or loan originator must give the borrower a full written disclosure itemizing all fees and costs within three business days of receiving a loan application. RCW 19.146.030(2)(a) then requires that disclosure to state, when the loan carries a variable rate, the circumstances under which the rate may increase, any limitation on the increase, the effect of an increase, and an example of the payment terms that would result from an increase.

Read plainly, that statute is a description of the adjustment period and its caps, put in front of the borrower in writing at the start rather than buried in the note at signing. A loan originator who quotes a low opening rate and never explains when it resets has a state disclosure problem, not only a sales problem. Real estate brokers do not quote loan terms and should not try, but they can ask a client one useful question: is the reset schedule in writing? Before steering a buyer toward an adjustable product, it is worth reviewing the loan types every Washington broker should know.

Example

Priya buys a Spokane townhouse for $410,000 with a 7/6 ARM at a starting rate of 5.75 percent. The 7 means that rate holds for seven years. The 6 means the rate then resets every six months. Her margin is 2.75 percent, her initial cap is 2 percent, her periodic cap is 1 percent, and her lifetime cap is 5 percent.

Seven years in, the index sits at 4.50 percent. Index plus margin is 7.25 percent, which is 1.50 percent above her starting rate, so the 2 percent initial cap does not bite and her new rate is 7.25 percent. Six months later the index climbs to 6.00 percent. Index plus margin would be 8.75 percent, but the 1 percent periodic cap holds her to 8.25 percent for that period. And no matter how far the index runs, her rate cannot pass 10.75 percent, because 5.75 percent plus the 5 percent lifetime cap is the ceiling for the life of the loan.

Common Mistakes and Exam Traps

• The adjustment period sets when a rate change is allowed. The rate cap sets how far the rate may move. Exam questions swap the two on purpose.
• In a 5/1 ARM the two numbers are years to the first change and reset frequency. They are not two different caps.
• A rate cap limits the interest rate. A payment cap limits the monthly payment, and a payment cap can produce negative amortization when the capped payment does not cover the interest owed.
• The index moves on its own and the margin stays fixed for the life of the loan, so a question about which piece of the rate changes at each adjustment is asking about the index.