There are many different types of Adjustable Rate Mortgages. Generally, interest on ARMs are determined by an outside index. Some examples of outside indexes are: the 6-month CD rate, the 1 year rate on Treasure Securities, the Federal Home Loan Bank’s 11th District Cost of Funds Index (COFI), or others.
Most ARM programs feature a “cap” that protects borrowers from sudden monthly payment increases. Your ARM may feature a cap on how much your interest rate can go up in one period. For example: no more than two percent per year, even if the underlying index increases by more than two percent. Your loan may have a “payment cap” that instead of capping the interest directly, caps the amount the monthly payment can increase in one period. Most ARMs also cap your interest rate over the life of the loan.
ARMs most often feature the lowest, most attractive rates toward the start. They provide that rate from a month to ten years. You’ve probably heard of 5/1 or 3/1 ARMs. In these loans, the introductory rate is set for three or five years. It then adjusts every year. These types of loans are fixed for 3 or 5 years, then adjust. Loans like this are often best for people who anticipate moving within three or five years. These types of adjustable rate programs are best for people who plan to sell their house or refinance before the initial lock expires.
Most borrowers who choose ARMs do so when they want to get lower introductory rates and don’t plan to remain in the home for any longer than the initial low-rate period. ARMs can be risky when housing prices go down because homeowners can get stuck with increasing rates if they can’t sell their home or refinance with a lower property value.