Mortgage holders are protected by a ceiling, or maximum interest
rate, which can be reset annually. ARMs typically begin with more
attractive rates than fixed rate mortgages — compensating the borrower
for the risk of future interest rate fluctuations.

Choosing an ARM is a good idea when:

• Interest rates are going down
• You intend to keep your home less than 5 years

ARMs have the following distinguishing features:

• Index
• Margin
• Adjustment Frequency
• Initial Interest Rate
• Interest Rate Caps
• Convertibility

IndexAn adjustable rate mortgage’s interest rate increases and
decreases based on publicly published indexes. ARMS are based on
different indexes including:

• United States Treasury Bills (T-bills)
• The 11th District Cost of Funds Index (COFI)
• London Interbank Offering Rate Index (LIBOR)
• Certificate of Deposit Indexes (CODI)
• 12-Month Treasury Average (MTA or MAT)
• Cost of Savings Index (COSI)
• Bank Prime Loan (Prime Rate)

MarginMargin is a fixed percentage amount that is pointed added to
the index – accounting for the profit the lender makes on the loan.
Margins are fixed for the term of the loan.

interest rate = index + margin

Adjustment FrequencyAdjustment frequency reflects how often the
interest rate changes – also known as the reset date. Most ARMs adjust
yearly, but some ARMs adjust as often as once a month or as infrequently
as every five years.Initial Interest RateThe initial interest rate is
the interest rate paid until the first reset date. The initial interest
rate determines your initial monthly payment, which the lender may use
to qualify you for a loan. Often the initial interest rate is less than
the sum of the current index plus margin so your interest rate and
monthly payment will probably go up on the first reset date.Interest
Rate CapsInterest rate caps put limits on interest rates and monthly
payments.

Common caps:

Initial Adjustment Cap

An initial adjustment cap limits how much the interest rate can change at the first adjustment period.Example:

If your ARM has a 1% initial adjustment cap, your interest rate may
only increase or decrease by a maximum of 1% at the first adjustment
period.

Periodic Adjustment Cap

A periodic adjustment cap limits how much your interest rate can
change from one adjustment period to the next. Usually a six-month
adjustable rate mortgage will have a one percent periodic adjustment cap
while a one-year adjustable rate mortgage will have a two percent
periodic adjustment cap.Example:

If your loan has a 2% periodic adjustment cap, your interest rate may
only increase or decrease by a maximum of 2% per adjustment period.

Lifetime Cap

A lifetime cap sets the maximum and minimum interest rate that you
may be charged for the life of the loan. Most ARMs have caps of 5% or 6%
above the initial interest rate. Example:

If your loan has a 6% lifetime cap, your interest rate may only
increase or decrease by a maximum of 6% for the life of the loan.

Initial adjustment caps, periodic adjustment caps, and lifetime caps
make up an adjustable rate mortgage’s cap structure, and are usually
represented as three numbers:

Example:

1/2/6 — Initial adjustment cap is 1 %/ periodic cap is 2% / lifetime cap is 6%.

Negatively Amortizing Loans Because Negatively Amortizing Loans
provide payment caps instead of interest rate caps, they limit the
amount the monthly payment can increase. However, there is a risk
interest rates could potentially escalate to a point where the monthly
payment would not cover the interest being charged. If this scenario
were to occur, the extra interest charges would be added to the
principle of the loan, resulting in the borrower owing more than was
initially borrowed. Borrowers are usually allowed to make payments over
the loan amount to pay down the mortgage and guard against this
scenario.

There are certain times when having a negatively amortizing mortgage
could be beneficial. If a borrower were to lose a job or have an
unexpected financial emergency a negative amortization option could ease
cash flow situation. However, this should only be used as a short-term
solution.

Option ARM loans Option ARM loans allow the borrower to choose the
amount to pay toward the mortgage each month. Make a minimum payment,
interest-only payment, 30-year amortized payment or 15-year amortized
payment. Pay the minimum amount to free up funds for other uses, or make
larger payments for faster equity build up. Option Arms offer much more
cash flow flexibility but must be used wisely by the borrower. Always
consult a qualified loan officer to learn about all of the risks
associated with these types of loans. He or she will also be able to
offer valuable advice on properly managing your monthly payments.