Adjustable Rate Mortgages (ARMs) come in even more varieties. Generally, ARMs determine what you must pay based on an outside index, perhaps the 6-month Certificate of Deposit (CD) rate, the one-year Treasury Security rate, or the Federal Home Loan Bank’s 11th District Cost of Funds Index (COFI) to name a few. They usually adjust once a year, after the original fix in period.
Most programs have a “cap” that protects you from your monthly payment going up too much at once. There may be a cap on how much your interest rate can go up in one period say, no more than two percent per year, even if the underlying index goes up by more than two percent. You may have a “payment cap” that, instead of capping the interest rate directly, caps the amount your monthly payment can go up in one period. In addition, almost all ARM programs have a “lifetime cap” — your interest rate can never exceed that cap amount, no matter what.
ARMs often have their lowest, most attractive rates at the beginning of the loan, and can guarantee that rate for anywhere from a month to ten years. You may have heard about loans that are called “3/1 ARMs” or “5/1 ARMs” or the like. That means that the introductory rate is set for three or five years, and then adjusts according to an index every year thereafter for the life of the loan. Loans like this are often best for people who anticipate moving, and therefore, selling the home within three or five years.
You might choose an ARM to take advantage of a lower introductory rate and count on either moving, refinancing again or simply absorbing the higher rate after the introductory rate goes up. With ARMs, you do risk your rate going up, but you also take advantage when rates go down by pocketing more money each month that would otherwise have gone toward your mortgage payment.