Additional Factors

Let's take a look at other aspects of the ARM loan you need to note when comparing mortgage products: 

Interest Caps
These limit how much your interest rate can fluctuate, and protect you from unexpected changes in the rate at adjustment periods and over the loan's lifespan. Caps vary among lenders, but are typically set at 2% and 6%.

There are two types of interest rate caps: lifetime and periodic.

• Lifetime Caps: These limit how much the interest rate can increase over the life of the loan. For example, if your loan had a "5% lifetime cap," your rate can not increase more than five percentage rate points over the initial rate no matter how high the index rate climbs. So, if you started with a 5.5% initial rate, the highest interest rate you could be charged on your loan would be 10.5%. By law, your mortgage contract must include a lifetime cap.
  
• Periodic Caps: These limit the interest rate increase from one adjustment period to the next. This cap shields the borrower from steep payment hikes from one adjustment period to the next. For example, your mortgage contract could provide that, should the index rate increase four points in one year, your rate could only rise two points.   

Payment Caps
This cap limits your monthly mortgage payment throughout the loan term, and requires that -- after an adjustment period -- your new monthly payment can only increase by a certain percentage of the previous payment.  Your mortgage contract will detail the increase. 

For example, the payment cap might indicate that your adjustment cannot increase more than 20% from your previous payment. If your old monthly payments were $500 per month, then the payment cap would limit the increase in your adjustment to 20% (or less) of $500. This would result in a maximum increase of $100, or a new payment of $600 ($500 x 1.20). The next adjustment could again increase another 20%, but would be based on the previous payment of $600. 

Payment caps can result in negative amortization during months when high interest rates require you to pay more than the payment cap allows. During months of negative amortization, the outstanding balance of the loan actually increases. During these months, your payments – due to the cap -- are insufficient to cover the cost of the loan created by a rising interest rate. This results in a monthly payment deficit.

Using our previous example, the payment cap limits the loan increase to 20%. However, a 25% increase would be necessary to cover the costs due to rising interest rates. So, if your payment amount is capped at $600, but you need to pay $625 to cover the interest, each month you would have a $25 payment deficit. In one year's time, you would accumulate an additional $300 towards your loan debt.  

At some point during the loan (usually towards the end), you will be required to make monthly payments large enough to pay off the principal and any accumulated interest you owe. When this day arrives, you might face repaying a large portion of the loan principal and accumulated interest in a shorter amount of time. This could translate into extremely large payments until the loan is completely paid off. 

Other questions to ask if you are considering an ARM loan include:

1. Conversion: Can you convert the ARM to a fixed-rate mortgage? A convertible ARM might enable you to lock in a lower fixed-rate at a later time.
2. Prepayment Penalties:  Will you have to pay a fee or penalty if you refinance or pay off the ARM early?
3. Any other concerns you have.