Adjustable Rate Mortgages — ARMs, as we called them above — come in even more varieties. Generally, the interest for ARMs are based on a federal index. Some examples of outside indexes are: the 6-month Certificate of Deposit (CD) rate, the 1 year Treasury Security rate, the Federal Home Loan Bank's 11th District Cost of Funds Index (COFI), or others.
Most programs have a cap that protects you from sudden increases in monthly payments. Some ARMs won't increase more than two percent per year, regardless of the underlying interest rate. Sometimes an ARM has a "payment cap" that ensures your payment will not increase beyond a fixed amount in a given year. Most ARMs also cap your rate over the life of the loan period.
ARMs usually start out at a very low rate that may increase as the loan ages. You've probably heard of 5/1 or 3/1 ARMs. In these loans, the initial rate is set for three or five years. It then adjusts every year. These loans are fixed for a certain number of years (3 or 5), then they adjust after the initial period. These loans are usually best for borrowers who expect to move within three or five years. These types of adjustable rate programs benefit borrowers who plan to sell their house or refinance before the initial lock expires.
You might choose an Adjustable Rate Mortgage to get a lower introductory interest rate and plan on moving, refinancing or absorbing the higher rate after the introductory rate expires. ARMs can be risky in a down market because homeowners can get stuck with increasing rates when they can't sell their home or refinance at the lower property value.
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