Adjustable Rate Mortgages

• Adjustable-rate mortgages -- ARMs -- are home loans with scheduled interest rate resets. The standard ARM reset is once a year. The new rate will be based on an interest rate index plus a margin rate specified in the contract. Hybrid ARM loans have an initial fixed rate for a period of three, five, seven or 10 years and then convert to an annual ARM for the balance of the loan term.
  
  

ARM Rate Caps

• An adjustable rate mortgage contract will include caps on how much the interest rate can change when it resets. One-year ARMs have two caps: an annual rate cap and a lifetime rate cap. Hybrid ARM loans with an initial fixed rate period of three years or more are written with a triple rate cap such as 5/2/5. The three rate caps are the limits on interest rate changes for the first rate adjustment, subsequent annual adjustments and the lifetime rate cap.
  
  

5/2/5 Rate Caps

• With a hybrid ARM with 5/2/5 rate caps, the first interest rate reset can't be more than 5 percent. For example, if the initial rate was 3 percent, the reset rate could be as high as 8 percent. Subsequent rate resets are limited to changes of 2 percent. If the first rate reset was less than the 5 percent maximum, future rate resets could be as much as 2 percent higher each year. The last 5 indicates the lifetime maximum rate change, or 5 percent. The loan with an initial 3 percent rate could never go higher than 3 plus 5 or 8 percent.
  
  

Rate Cap Considerations

• A hybrid ARM with 5/2/5 rate caps will cause the most problems for a home owner at the first rate reset if the full cap amount is used. An increase of 5 percent would result in a significant payment increase. For example, a $200,000 loan with the rate fixed at 3.5 percent for five years would start with a payment of $898. If the rate jumped to 8.5 percent after five years, the new payment would be $1,447; an increase of over $500.