Hybrid ARMs -- 3/1, 5/1, 7/1 and 10/1 ARMs

These loans are fixed for a set period -- either 3, 5, 7 or 10 years -- and then become adjustable on an annual basis thereafter (that's what the "1" refers to).  During the fixed period, no matter what happens to interest rates, your rate will not change. These loans generally do not require a prepayment penalty.

These are "pay as you go" mortgages, which means your payment always includes principal and interest (unless you get an "interest-only" loan).  They are based on either the One Year Treasury Bill, the One Year Treasury Average, the LIBOR or the 6 Month C.D. index, plus a pre-determined "margin", which is added to the underlying index when the loan adjusts.

A typical hybrid loan has an interest-rate cap of 2% once the loan starts adjusting, but the initial payment cap can be higher. The lifetime cap is generally 5 or 6% over the initial rate (eg: the initial rate is 7.875%, and the lifetime cap is 13.875%). This means your interest rate will never exceed this predetermined cap, no matter how high the underlying index goes.

Hybrid ARM Indices

One Year T Bill Index
This index is based on the results of auctions that the U.S. Treasury holds for its Treasury bills, which are issued by the U.S. government with maturities of 3, 6 months, and 1 year in order to pay for the national debt and other expenses. The Treasury Bill index moves with the market and responds quickly to economic changes.

The CMT Index
This index is the weekly or monthly average yields on U.S. Treasury securities adjusted to constant maturities. Yields on Treasury securities at "constant maturity" are interpolated by the U.S. Treasury from the daily yield curve, which is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market.

The Treasury indices are somewhat volatile and move with the market.

LIBOR Index
The London Inter Bank Offering Rate (LIBOR) is an average of the interest rate on dollar-denominated deposits, also known as Eurodollars, traded between banks in London. The Eurodollar market is a major component of the International financial market.

The LIBOR is an international index which follows the world economic condition. It allows international investors to match their cost of lending to their cost of funds. The LIBOR compares most closely to the 1-Year CMT index and is more open to quick and wide fluctuations. There are several different LIBOR rates widely used as ARM indexes: 1-, 3-, 6-Month, and 1-Year LIBOR. The 6-Month LIBOR is the most common.