Adjustable Rate Mortgages (ARM) are loans whose interest rate can vary during the loan's term. These loans usually have a fixed interest rate for an initial period of time. Once the initial fixed period expires, ARM loans adjust based on current market conditions. The initial rate on an ARM is lower than on a fixed rate mortgage which may provide more buying power. Adjustable rate mortgages are usually amortized over a period of 30 years to help keep monthly mortgage payment low. The initial rate is typically fixed for 5 years, 7 years, or 10 years.
Adjustable Rate Mortgages (ARM) have a "margin" plus an "index" to determine rates. You add the margin and the index to get your fully indexed rate. The margin is a fixed percentage. The index is the financial instrument that the ARM loan is tied to, such as: 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI).
When the time comes for the ARM to adjust, the margin will be added to the index and typically rounded to the nearest 1/8 of one percent to arrive at the new interest rate. That rate will then be fixed for the next adjustment period. This adjustment can occur every year, but there are factors limiting how much the rates can adjust. These factors are called "caps". Suppose you had a "5/1 ARM" with an initial cap of 2%, a lifetime cap of 6%, and initial fixed interest rate of 3.25%. The highest rate you could have in year 6 would be 5.25%. The highest rate you could have during the life of the loan would be 9.25%.
Make sure you review the terms of any Adjustable Rate Mortgage (ARM) with an experienced mortgage professional to determine your margin, index, adjustment caps, adjustment periods, and intial fixed period so you are prepared.