An Adjustable Rate Mortgage is also called a ARM. The interest rate on an ARM will periodically change, unlike mortgages that have fixed rate and have an interest rate that
remains the same for the life of the loan. The initial interest rate of an Adjustable Rate Mortgage is lower than that of a fixed rate mortgage, consequently, a good option to consider, if you plan
to own your home for only a few years, is a Adjustable Rate Mortgage; or, the prevailing interest rate for a fixed rate mortgage is too high; or, you expect an increase in future earnings.
An Adjustable Rate Mortgage has four components: (1) an margin, (2) a index, (3) an initial interest rate period, (4) and an interest rate cap structure. The new interest rate is calculated by adding a margin to the index when the initial interest rate period has expired. At time of loan application your lender will disclose the margin. It's is a good idea to shop around for a low margin because margins may vary from lender to lender. Your interest rate will be adjusted accordingly as the index figure moves down or up. FHA insured Adjustable Rate Mortgages use the Constant Maturity Treasury index (weekly average yield of U.S. Treasury securities, adjusted to a constant maturity of one year). Decreases or increases in the interest rate will be limited by the interest rate cap structure of your loan.
The interest rate cap structure provides some protection from large interest rate swings. There are two types of caps: (1) life-of-the-loan, and (2) annual. The life-of-the-loan cap limits the minimum (and maximum) interest rate you can pay for as long as you have the mortgage while the annual cap restricts the amount your interest rate can change, up or down, in any given year. FHA offers a four "hybrid" ARM products and a standard 1-year ARM. Hybrid ARMs offer an initial interest rate that is constant for the first 3-, 5-, 7- or 10 years. The interest rate will adjust annually after the initial period,. Below are the different interest rate cap structures for the various ARM products:
5-, 7- and 10-year hybrid ARM have annual caps of two percentage points, and life-of-the-loan caps of six percentage points.
1-year ARM and 3-year hybrid ARM have annual caps of one percentage point, and life-of-the-loan caps of five percentage points. (Example - if your initial interest rate were 5.00%, the highest possible interest rate would be 10.00%)