An ARM has four components: (1) an index, (2) a margin, (3) an interest rate cap structure, and (4) an initial interest rate period. When the initial interest rate period has expired, the new interest rate is calculate
d by adding a margin to the index. Your lender will disclose the margin at time of loan application (margins may vary from lender to lender, so it’s is a good idea to shop around for a low margin). As the index figure mo
ves up or down, your interest rate will be adjusted accordingly. Acceptable index options on FHA insured ARM loan transactions are 1) the Constant Maturity Treasury (CMT) index (weekly average yield of U.S. Treasury securities, adjusted to a constant maturity of one year); or 2) the 1-year London Interbank Offered Rate (LIBOR). Increases or decreases 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) annual, and (2) life-of-the-loan. The annual cap restricts the amount your interest rate can change, up or down, in any given year, while the life-of-the-loan cap limits the maximum (and minimum) interest rate you can pay for as long as you have the mortgage. FHA offers a standard 1-year ARM and four “hybrid” ARM products. Hybrid ARMs offer an initial interest rate that is constant for the first 3-, 5-, 7-, or 10 years. After the initial period, the interest rate will adjust annually. Below are the different interest rate cap structures for the various ARM products:
- 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%)
- 5-, 7-, and 10-year hybrid ARM have annual caps of two percentage points, and life-of-the-loan caps of six percentage points.