The adjustment period.
With most ARMs, the interest rate and monthly payment change every year, every two years, every three years, or every five years. However, some ARMs have more frequent rate and payment changes. The period between one rate change and the next is called the "adjustment period". A loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change once every year.
The index.
Most lenders tie ARM interest-rate changes to changes in an "index rate."
These indexes, and there are several types of indexes, usually go up or down with the general movement of interest rates. If the index rate goes up, so does your mortgage rate and payment in most circumstances. On the other hand, if the index rate goes down, your monthly payment may go down.
Lenders base ARM rates on a variety of indexes. Among the most common indexes are the rates on one-, two-, three-, or five-year Treasury securities.
Another common index is the national or regional cost of funds to savings banks. A few lenders use their own cost of funds as an index, which gives them more control than using other indexes. Another common index is the LIBOR rate.
The margin.
To determine the interest rate on an ARM, lenders add to the index rate a few percentage points called the "margin." The amount of the margin may differ from one lender or investor to another, but it is usually constant over the life of the loan.
The lowest possible payment.
With their "usually lower than fixed rate" interest rates, and coupled with interest only payments, an ARM (Adjustable Rate Mortgage)... especially a short-term ARM... could represent a way to have the lowest possible monthly payment, and still make it possible for you to own your own home. Some mortgage products, allow you to have your choice of payment plans, including interest only, fully-amortizing or accelerated-amortizing. These so-called, "12 mat", "option arms" or "pick-a-payment" mortgages are gaining in popularity, as they allow you to determine how best to apply your budget to your mortgage. These option arm products should not be confused with zero down, interest only loans, because they are not 100% financing products. The highest LTV (Loan-To-Value) available with any option ARM product offered by any lender in the country is 95%. So, to use an option ARM as a purchase mortgage, you'd need to have at least a 5% down payment.
If you think you're a candidate for an ARM, and if you have college, retirement or investment needs to take care of, you might consider adding interest only payments to your ARM in order to more fully fund the other financial needs in your life. You may believe your home will be worth more in the future... or that you can invest the money better elsewhere than paying down your mortgage balance. As far as maximizing your tax deduction, remember that not only is the vast majority of your payment already comprised of interest, but only a fraction of every dollar in interest you spend is tax deductible, anyway