Courtesy Financial... adjustable rate mortgage options

Adjustable Rate Loans
(30 year amortization)
These mortgages usually have a term of 30 years and the interest rate fluctuates throughout the life of the loan, based on some index. There are many kinds of Adjustable Rate Mortgages (ARM). Some adjust every year, every 6 months, or even every month. The most common index is a T-Bill ARM. A One Year T-Bill ARM with 2/6 Caps adjusts once per year using the Treasury Bill as it's index and won't increase more than 2% a year and 6% over it's lifetime. The advantages of an ARM are that the initial rate usually start lower than the market fixed rates. The disadvantages are that the rate may increase or decrease over the life of the loan and your exact payments over time are unpredictable.

The Adjustable Rate Mortgage (ARM)
With an ARM loan, the annual percentage rate of the loan may increase or decrease during the life of the loan. By contrast, a fixed rate loan has a rate that remains constant throughout the term of the loan.

What determines the interest rate?

INDEXES
The interest rates on ARM loans are usually based on an index. An index follows the overall condition of the economy and is a measurement of the relative cost of funds at any given time. Generally, the interest rate on an ARM loan rises when an index increases and falls when an index decreases. Some examples of different indexes include: the Wall Street Journal Prime Rate, the weekly average yield on U.S. Treasury Bills, the LIBOR index or the Cost of Funds Index.

MARGINS
The interest rates on adjustable rate mortgage loans that are tied to indexes are generally determined by the addition of a margin.

index + margin = interest rate

A margin is a pre-determined amount that is added to an index value in order to arrive at an interest rate. For example:

Index (2.13%) + Margin (2.00%) = Interest Rate (4.13%)

What determines an adjustment?

CAPS
Life Caps: Because ARM loans are tied to the economy, they can be subject to significant interest rate changes over the life of the loan. A life cap is the maximum rate of interest that can be charged for a particular ARM loan. Every ARM loan must have a life cap that is determined when the loan is made. A life cap can be expressed in two ways. It can be a predetermined maximum rate of interest such as 12.75%. Or, it can be expressed in terms of a maximum amount of change from the initial interest rate, such as 6.00% above the initial interest rate at the inception of the loan.

Payment Caps: In addition to life caps, most ARM loans may have another type of cap, known as an "payment cap." This cap is a limit on the amount the interest rate can change at any one time. The frequency with which adjustments can occur will be determined when the loan is made. A common payment cap is 2.00% per year.

Using our pervious example of 6.13%, if the maximum amount the interest rate could change at the next adjustment is 2.00%, then the interest rate could go no higher than 8.13%, or no lower than 4.13%, even if the index were to change by more than 2.00%. The idea behind payment caps is to minimize the financial impact of adjustments to a loan.