Adjustable Rate Mortgages (ARMs) are loans where the interest rate on the mortgage is periodically adjusted during the loan's term. These loans usually have a fixed interest rate for an initial period of time and then can adjust based upon current market conditions. Since the 1970's, lenders have often encouraged borrowers to consider ARM programs by offering lower initial interest rates, compared to the traditional fixed rate loan. The lenders many times offer lower monthly payments in exchange for the borrower taking on more of the lenders risk for higher interest rates in the future. When rates are low like we've experienced for the past few years, ARM's lose their attraction since many people like the security of a fixed rate option. However when rates rise as we're starting to see now, ARM's are coming back as a viable option. 

Adjustable rate mortgages are usually amortized over a period of 30 years with the initial interest rate being fixed for anywhere from 1 month to 10 years. All ARM's have 2 components: the index and the margin. The index is what the lender uses as an instrument for measuring changes in interest rates. It's the lender's barometer of change in interest rates. Lenders base ARM rates on a variety of indexes. Among the most common indexes are the 1-year constant-maturity Treasury Rate (CMT), the 11th District Cost of Funds Index (COFI) and the London Interbank Offered Rate (LIBOR). 

The margin is the percent added to the index in order to calculate the payment interest rate. Margins vary from one lender to another, remain fixed for the term of the loan and are not impacted by the financial markets and movement of interest rates. Lenders use a variety of margins depending upon the loan program and adjustment periods.

The fully indexed rate is equal to the margin plus the index and is usually rounded up to the nearest 1/8 of a percent. For example, if the lender uses an index that currently 1.50% and adds a 2.50% margin, the fully indexed rate would be 4.00% and that is what your new monthly payment would be based upon. 

An interest rate cap places a limit on the amount the interest rate and increase or decrease at each adjustment date. There are 3 caps that can be utilized on an ARM loan. 

A per adjustment cap, which limits the amount the interest rate can adjust up or down from one adjustment period to the next after the first adjustment.  

A lifetime cap on the interest rate limits the amount the interest rate may increase or decrease during the life of the loan.

ARM's that offer a fixed rate period during the first years of the loan usually have an initial rate payment adjustment cap that is higher than the per rate adjustment cap thereafter during the loan term. 

For example:

Caps of 1/5 - 1% per adjustment cap and a 5% lifetime cap

Caps of 2/6 - 2% per adjustment cam and a 6% lifetime cap

Caps of 3/2/6 - 3% initial adjustment cap, 2% per adjustment cap and a 6% lifetime cap

To understand an ARM, you must have a working knowledge of it's components. These components are:

Index: A financial indicator that rises and falls, based primarily on economic fluctuations. It is usually an indicator and is therefore the basis of all future interest adjustments on the loan. Mortgage lenders currently use a variety of indexes. 

Margin: I associate margin as a lender's profit on the loan. The margin is added to the index (lender's cost) to determine the interest rate for the current adjustment period.  

Initial Rate: The rate during the initial period of the loan, which is sometimes lower than the note rate. This is referred to as a "teaser rate", an unusually low rate to entice buyers. 

Note Rate: The actual interest rate charged for a particular loan program.

Adjustment Period: The interval at which the interest is scheduled to change during the life of the loan.

Interest Rate Caps: The limit placed on the up-and-down movement of the interest rate, specified per period adjustment and lifetime adjustment.