β In times of rising rates, it's smart for adjustable-rate borrowers to look at worst-case scenarios. Experts suggest that you look at four things in the loan agreement: the index, the margin, the adjustment periods and the "caps."
l Index:
The most common indexes are the cost-of-funds index, a slow-moving measure of what Western banks are paying for consumer deposits; the London Interbank Offered Rate, or Libor, which reflects what banks charge one another for short-term borrowing; and the constant-maturity Treasury index. At the moment, all of these indexes are in the 1.5 percent to 2.5 percent range.
β Margin:
To determine the "fully phased-in" rate on an adjustable loan, you add the index to a margin - usually 1.4 to 2.4 percentage points. That margin reflects the bank's profit and administrative costs on the loan.
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β Adjustment periods:
The interest rate remains settled until the adjustment period. When that adjustment will occur depends on the type of ARM. Monthly adjustables can change once a month, but there are also loans that adjust once every three months, once every six months and once a year. Hybrid adjustables offer a longer fixed-rate period - three to 10 years at the start of the loan - then adjust once annually after that.
l Caps:
Most contracts also insulate borrowers from rapidly rising interest rates by setting caps on either payments or interest rates. Short-term ARMs, such as monthly adjustables, typically offer a payment cap of 7.5 percent a year. In other words, if the required monthly payment was $100, it couldn't go higher than $107.50 the following year.
β Payment caps aren't tied to interest rates, and the borrower could end up with something called "negative amortization." In the above example, that means that if rates rose enough to push the required monthly payment to $120, but your payment cap limited the payment to $107.50, the $12.50 monthly difference would be added to the balance of the loan.
β One-year and hybrid adjustables generally offer annual interest rate caps, which promise to limit rate increases to no more than 2 percentage points a year. In addition, nearly all adjustable loans have lifetime interest rate caps.