How an ARM actually resets: the three caps, in order

An adjustable-rate mortgage note doesn't just say "the rate follows the index." It says the rate follows the index, subject to three separate caps — an initial cap on the first reset, a periodic cap on every reset after that, and a lifetime cap that's an absolute ceiling no reset can cross. Applying them out of order is the single most common way a homeowner's own back-of-envelope projection ends up wrong.

The method

At every reset, compute the fully-indexed rate first: index + margin, both taken off your current statement and note. Then apply the per-reset cap — the initial cap at the first reset, the periodic cap at every reset after that — as a band around the rate you're currently paying: the new rate can move at most that many points up or down from where it already is. Only after that per-reset band is applied do you clamp the result to the lifetime cap, the absolute ceiling (or floor) measured from your starting rate. Doing the lifetime clamp first and the periodic band second can push a rate above the lifetime cap by mistake — the order matters.

A worked example

A $310,000 balance, 30-year (360-month) term, starting at 3.25% fixed for the first 5 years (60 months). Index is now 5.10%, margin is 2.25% (fully-indexed rate: 7.35%). Initial cap: ±2 points. Periodic cap: ±1 point. Lifetime cap: 5 points above the start rate, so 3.25% + 5% = 8.25%. Resets happen every 12 months after the first.

Starting payment at 3.25% over 360 months: $1,349.14. Balance at month 60, the first reset: $276,850.95.

1. Reset 1 (month 60): target is the fully-indexed 7.35%. Initial cap bands the move to 3.25% + 2% = 5.25% at most — 7.35% is above that band, so the initial cap holds it down to 5.25%. New payment on the $276,850.95 balance over the 300 months left: $1,659.02.
2. Reset 2 (month 72): target is still 7.35%. Periodic cap bands the move to 5.25% + 1% = 6.25% — still below the target, so the periodic cap holds it to 6.25%. New payment: $1,821.21.
3. Reset 3 (month 84): band is 6.25% + 1% = 7.25% — still below 7.35%, held to 7.25%. New payment: $1,985.54.
4. Reset 4 (month 96): band is 7.25% + 1% = 8.25%, which now covers the 7.35% target. No cap binds — the rate lands at the fully-indexed 7.35%, and it's still under the 8.25% lifetime ceiling. New payment: $2,001.83.

It took four resets — three of them capped, not free — for the rate to catch up to what the index and margin actually justified. Reading the fully-indexed rate off the statement and assuming the payment jumps there immediately overstates the near-term payment; reading the low first-reset rate and assuming it holds understates where the payment is headed.

The worst case

The worst case isn't the fully-indexed rate — it's the index running up faster than the caps allow, so every reset moves the full cap amount until it hits the lifetime ceiling. Same loan: reset 1 to 5.25% (the full initial cap), reset 2 to 6.25%, reset 3 to 7.25%, reset 4 to 8.25% — the lifetime ceiling, reached in exactly 4 resets because each periodic cap is 1 point and there's exactly 3 points between 5.25% and 8.25%. Payment at that ceiling: $2,151.23, up $802.09 from the starting $1,349.14. That's the highest payment this note allows, and it's the number worth knowing before signing, not after the first reset notice arrives.

What this doesn't include

This is the cap arithmetic only — it takes the index and margin you enter and does not predict where rates go next. It assumes a rate floor of 0% unless your note states a floor equal to the margin, in which case downward moves may be shallower than shown. It's not financial advice, and the numbers above are a made-up example, not typical terms; every input should come from your own note and statement.

Run your own numbers

The free ARM Reset Projector tool takes your balance, rate, index, margin and caps, and projects the rate and payment at every reset — which cap bound each one, and the worst case if the index runs ahead of every cap — entirely on your device.