A good textbook definition of adjustable rate mortgageii is: "a mortgage with an interesti ratei that is linked to an economic indexi." What that means is that the interest rate, and your payments, are periodically adjusted up or down as the index fluctuates. Below we define some of the terminology you'll hear when talking with lenders or mortgage brokers about ARMs.

Index

The index of an ARM is the financial instrument that the loan is "tied" to, or adjusted to. Each adjustable rate mortgage is linked to a specific index. The most common indices, or, indexes are the 1-Year Treasury Securityi, LIBOR (London Interbank Offered Rate), Prime Ratei, 6-Month Certificate of Depositi (CD) and the 11th District Cost of Funds Indexi (COFI). Each of these indices move up or down based on conditions of the financial markets.

Margini

Think of the margin as the lender's markup. It is an interest rate that represents their cost of doing business plus the profit they will make on the loan. The margin is added to the index rate to determine your total interest rate. The margin added to the index is known as the fully indexed ratei. As an example, if the current index value is 4.50% and your loan has a margin of 2.25%, your fully indexed rate is 6.75%. Margins on loans usually range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property value. Your rate may change during the life of the loan, but the margin usually stays the same.

Adjustment periodi

The adjustment period is the period between rate adjustments. You may see an adjustable rate mortgage described with figures such as 1-1, 3-1, and 5-2. The first figure in each set refers to the initial period of the loan, during which your interest rate will be the same as it was on the day of closingi. The second number is the adjustment period, showing how often adjustments can be made to the rate after the initial period has ended. In the examples above the first two ARMS have annual adjustments after the 1st and 3rd years, respectively. The last example has a semiannual adjustment period.

Interim Caps

All adjustable rate loans carry interim caps. Many ARMs have interest rate capsi of six-months or a year. There are loans that have interest rate caps of three years. Interest rate caps are beneficial in rising interest rate markets, but can also keep your interest rate higher than the fully indexed rate if rates are falling rapidly.

Payment Caps

Some loans have payment caps instead of interest rate caps. These loans reduce payment shock in a rising interest rate market, but can also lead to deferred interest or "negative amortizationii". These loans generally capi your annual payment increases to 7.5% of the previous payment.

Lifetime Caps

Almost all ARMs have a maximum interest rate or lifetime interest rate cap. The lifetime cap varies from company to company and loan to loan. Loans with low lifetime caps usually have higher margins, and the reverse is also true. Those loans that carry low margins often have higher lifetime caps.

Adjustable Rate Mortgage Advice:

If my payments can go up, why should I consider an Adjustable Rate Mortgage?
The initial interest ratei for an ARM is lower than that of a fixed rate mortgage (where the interest rate remains the same during the life of the loan). A lower rate means lower payments, which might help you qualify for a larger loan.

Points to remember about an Adjustable Rate Mortgage:

• The possibility of higher rates isn't as much of a factor if you plan to be in the home for a relatively short time.
• Do you expect your income to increase? If so, the extra funds may cover the higher payments that result from rate increases.
• Some ARMs can be converted to a fixed-rate mortgage. However, conversioni fees may be high enough to take away all of the savings you saw with the initial lower rate.
• While you normally can't dictate which index a lender uses, you can choose a lender based on which index will apply to your loan. Ask how each index has performed in the past. Your goal is to find one that has remained fairly stable in economic downturns.
• When comparing lenders, consider both the index and the margin rate being offered.
• If the lender doesn't plan to sell your loan on the secondary market, you might be able to avoid the Private Mortgage Insuranceiii (PMIi) that's normally required when a buyer makes less than a 20% down paymenti.