On all ARMS, there is cap limit on how much interest rate may increase or decrease. There are generally 2 types of cap limit. One is called "Adjustment Cap" and the other is called "Lifetime cap." Adjustment Cap sets the limit on how much the interest rate can increase or decrease. For example, if adjustment cap is set at 2% and your current interest rate is 6%, that means your new interest rate can not go above 8% or below 4%. For lifetime cap, it sets the maximum interest rate you can ever pay in any given year over your start rate. For example, a 6% lifetime cap means that your interest rate can go up 6% over your start rate. If your start rate was 6%, that means the lender can charge you 12% interest!
Anyway, interest rate on ARMS are base on how the securities market is doing. Mortgage interest rates are tied to current market conditions and a good measure of market conditions are yields on treasury securities. The index is normally the weekly average yield on a 1, 3 or 5 Year Treasury Security 30 or 45 days prior to your adjustment date. Keep in mind, a 1 Year Treasury yield is lower than a 5 Year Treasury yield.To this index, the lender will add a margin of X% determined solely by the lender. A lender could add a margin of 2.25%, 2.5% up to or greater than 3% to the index to determine your new rate. When shopping for an ARM you want to look for the lowest term treasury security index with the lowest margin.
The Caps, Margin and Index play an important deciding factor when shopping for an ARM. For example; you have been quoted the following rates and terms on a 3/1 ARM both with a 1 Year Treasury Security index:
Loan #1 - Rate 6.00%: Caps are 2% per adjustment, 6% lifetime with a Margin of
Loan #2 - Rate 6.125%: Caps are 2% per adjustment, 5% lifetime with a
Margin of 2.50%
On the surface, loan #1 looks like the better loan since the interest rate is .125% lower than loan #2 and that holds true if you plan on moving or refinancing your loan at the end of the three years. But if there is a chance you will keep the loan beyond 3 years, loan #2 is probably the better way to go because 1) when loan #2 adjusts, the rate will always be .25% below loan #1 (unless it adjusts the full 2%) and 2) the lifetime cap is a full 1% lower than loan #1.
Is ARM right for you? Well, how long do you plan to live in the home? Are you going to refinance before the interest rate adjustment? Are you able to afford the highest interest payment?
ARM are not for everyone. If you can't afford the highest interest payment and/or you need to refinance, then a 30 year fix rate loan is the way to go.