Here are some important terms/features to understand regarding ARMs in general:

FIXED-RATE PERIOD
Every ARM has an introductory period in which the rate is fixed. Some ARMs offer only a 6 month fixed-rate period while products like a 10-year ARM are fixed for the first 10 years and then adjust. A “10-year ARM” by the way is exactly the same as a “10-year FIXED” - they’re simply interchangeable names! Once the Fixed-Rate Period is over, the rate is calculated in a completely different way, by adding the loan's Margin to its Index.

INDEX
Every ARM product tracks a particular Index. That is, after the Fixed-rate Period expires, the rate on the ARM changes according to the rate of the Index it tracks. There are many different indices that I-O loans track, each with unique histories, features and futures. Some examples of ARM Indices include the LIBOR(London InterBank Offered Rate), the T-Bill(Treasury Bill), the COFI(Cost of Funds Index), the MTA(Monthly Treasury Average) and more – you likely have never even heard of these!

MARGIN
The Margin is the amount added to the Index to arrive at the current rate(after the Fixed-Rate Period is up). All ARM products are priced up-front with a particular Margin that does not change. Margins on some I-O ARMS are quite low, around 1.5-3% while Margins on other I-O ARM products are as high as 5-8%. One key discussed later in this tutorial is the grave importance of obtaining a LOW Margin if you are going to keep the loan beyond its initial Fixed-Rate Period.

CALCULATING THE RATE
To calculate the rate on an ARM product after the Fixed-rate Period is over, simply add the Margin to the Index. If the Margin is 2.5%, and the Index is currently 1.5%, the current Rate would be 4.0%. Remember that the Margin never changes but the Index may change as often as every month or 6 months on some I-O loans.

CAPS
Caps are restrictions that limit the rate increases during the adjustment period. If the initial fixed rate was say 3.5% and now, when the fixed-rate period expires, the Index plus Margin equals say, 8%, the CAPS would restrict the rate increase, thereby allowing consumers to avoid incurring "payment shock" from their rate rising too quickly.

PRE-PAYMENT PENALTIES (PPPs)
Pre-payment Penalties are a fairly common feature of I-O loans. Because some I-O loans offer truly stellar introductory pricing, lenders want consumers to keep the loan beyond this intro period so they often require a PPP in order to induce consumers to hold the loan long enough for the lender to recoup its costs and turn a profit. There are 2 types of PPP:

Hard : assessed if the loan is paid off for any reason within the PP Period

Soft : assessed if the loan is paid off due to refinancing within the PP Period