Typically annual caps are 2 percent and lifetime caps are 6 percent.  This means that the home loan interest rate cannot go higher than 2 percent over the previous year’s rate, and will never be more than 6 percent over the initial interest rate.

If you have a home loan where the interest rate changes monthly or every six months, the caps should be no more than 1 percent, and there should be a lifetime cap of 5 percent.

Beware of home loans with no annual cap and only a lifetime cap.  The interest rate might reach maximum immediately.

The index is an economic indicator chosen to determine what a home loan’s interest rate will be when it adjusts.  It is the base number that changes each time your interest rate is due for a change.  Common indexes are 1-year T-Bill, Cost of Funds District (COSI), London Interbank Rate (LIBOR), and Monthly Treasure Average (MTA).  You should pick an Index that does not fluctuate a lot over a long period of time.

Historically, the MTA is the most stable index, but it is hard to figure out.  If you want an ARM based on the MTA, get professional advice.

The home loan’s adjustment in interest rate is set by the index plus a margin.  The margin is established at the beginning of the loan and never changes.  An average margin on a residential home loan is around 2.75 percent and will be the same for the entire loan.  The margin is typically not negotiable for home loans.

The higher the margin, the more interest the lender can earn over the life of the loan.  If there is a mortgage broker or mortgage banker involved, then the higher the margin, the higher the fee the lender will pay them for the loan.

Here is an example of how a new interest rate would be figured:

The home loan is a 1- year ARM, with monthly payments based on a 30-year term.
Initial rate of 5 percent
Index is 1-year T-Bill
Loan margin is 2.75 percent
Caps are 2 percent annual and 6 percent lifetime

At the first anniversary of the interest rite change, the index for 1-year T-Bill is 6.17 percent.  So the new rate based on the indues plus the margin is:

6.17 + 2.75 = 8.92 percent

However, the annual cap is 2 percent over the prior year’s interest rite, so the rate will be less:

5 + 2 = 7 percent

Also, because there is a lifetime cap of 6 percent, the highest the interest rate can go is:

5 + 6 = 11 percent