Adjustable Rate Mortgage Overview

Most adjustable-rate mortgages have caps to limit how much the interest rate and your monthly mortgage payments can be raised when your ARM interest rate is adjusted.

The most common ARM caps are the "initial cap", "periodic cap", and "lifetime cap". The initial cap limits how much the interest rate can be increased the first time it is adjusted. The periodic cap limits how much the interest rate can be increased each subsequent time it is adjusted, after the initial adjustment. The lifetime cap sets a maximum amount by which the interest rate can be increased as long as you keep the loan.

The caps on your ARM, along with the adjustment periods, margin and index, should be disclosed in your loan documents. If these documents aren't handy or you can't find the information you need, call the telephone number on your mortgage statement and ask the lender or loan servicing company to assist you.

For an ARM, the adjustment interval is the time between changes in the interest rate and/or monthly payment, usually one, three, or five years. The adjustment periods should be disclosed in your original loan documents.

The margin is the amount a lender adds to the index on an adjustable-rate mortgage to establish the adjusted interest rate. The margin on your ARM should be disclosed in your original loan documents.

A hybrid ARM combines the features of a fixed-rate mortgage with those of an ARM. Like a fixed-rate mortgage, the loan's interest rate is stable for up to ten years. After the initial period, however, it converts to an ARM, and the rate is adjusted every year for the remaining life of the loan.

You'll see hybrids referred to as 3/1 or 5/1, and so on. The first number is the length of the fixed term - usually three, five, seven, or ten years. The second is the adjustment interval that applies when the fixed term is over. So, with a 7/1 hybrid, you pay a fixed rate of interest for seven years; after that, the interest rate will change annually.

Lenders base their ARM interest rates on an index rate and add a predetermined margin to calculate your final or fully-indexed rate. Changes to the index rate dictate how your mortgage rate will adjust at each adjustment period. Lenders use different types of indexes to set ARM rates and these index rates can differ significantly. Some indexes are relatively stable, while others tend to be far more volatile. Often, ARMs based on more stable indexes carry a higher margin than those based on indexes that are more apt to react quickly to market conditions.

The indexes most often used by lenders are:

• 12-Month Treasury Average (MTA): This index, also known as the 12-Month Moving Average Treasury index (MAT), is based on a moving average of the monthly yields on U.S. Treasury securities. It is adjusted once a month and moves slowly, lagging behind the other indexes.
• 11th District Cost of Funds index (COFI): This widely used index is calculated monthly, based on the weighted average of interest rates paid on savings and checking accounts by institutions in the 11th Federal Home Loan Bank District (consisting of banks based in Arizona, California and Nevada). Its rate also tends to change slowly.
• Constant Maturity Treasury indexes (CMT): These indexes follow the average weekly or monthly yields on U.S. Treasury bills. They are more attuned to events in the economy and can change rapidly. The one-year CMT is widely used for mortgages with annual rate adjustments.
• London Interbank Offered Rate indexes (LIBOR): These are based on the average interest rates at which London banks borrow funds from each other. They are more volatile than the COFI or MTA indexes. However, LIBOR-based mortgages tend to have low initial rates. They also tend to have lifetime and periodic interest rate caps to protect borrowers from spikes in the index rate.