From Justin Pritchard,
Your Guide to Banking / Loans.
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Now you're up to speed on how ARM mortgages work. Let's look at how they sometimes don't work in your favor. Note that the term ARM Mortgage is redundant - the "M" is for mortgage - but we'll use this term throughout this page for familiarity.

ARM mortgage caps can work in a variety of ways. There are periodic caps and lifetime caps. A periodic cap limits how much your rate can change during a given period – like a one year period. Lifetime caps limit how much your ARM mortgage rate can change over the entire life of the loan.

ARM Mortgage Examples

Assume you have a periodic cap of 1% per year. If rates rise 3% during that year, your ARM mortgage rate will only rise 1% because of the cap. Lifetime caps are similar. If you’ve got a lifetime cap of 5%, the interest rate on your loan will not adjust upward more than 5%.

Keep in mind that interest rate changes in excess of a periodic cap can carry over from year to year. Consider the example above where interest rates rose 3% but your ARM mortgage cap kept your loan rate at a 1% increase. If interest rates are flat the next year, it’s possible that your ARM mortgage rate will rise another 1% anyway -- because you still “owe” after the previous cap.

There are a variety of ARM mortgage flavors available. For example, you might find the following:

• 10/1 ARM Mortgage – the rate is fixed for 10 years, then adjusts every year (up to the cap, if any)
• 7/1 ARM Mortgage – the rate is fixed for 7 years, then adjusts every year (up to the cap, if any)
• 1 Year ARM Mortgage – the rate is fixed for one year then adjusts annually up to any caps

Not All Caps are Created Equal

Note that caps may differ over the life of your loan. The first adjustment may be up to 5%, while subsequent adjustments may be capped at 1%. If this is the case on an ARM mortgage you’re considering, be prepared for a wild swing in your monthly payments when the first reset rolls around.

Pitfalls of Caps

While caps and restrictions may protect you, they can cause some problems. For example, your ARM mortgage may have a limit on how high the monthly payment will go – regardless of movements in interest rates. If rates get so high that you hit the upper (dollar) limit on your payments, you may not be paying off all the interest you owe for a given month. When this happens, you get into negative amortization –meaning your loan balance actually increases each month.

Buyer be Aware

The bottom line with ARM mortgages is that you need to know what you’re getting into. Your lender should explain some worst-case-scenarios so that you aren’t blindsided by payment adjustments. Most borrowers look at these what-ifs and assume that they will be in a better position to absorb payment increases in the future – whether it’s 5 or 10 years out. This very well may be the case, but things don’t always work out the way we’ve planned.