Adjustable-rate mortgages or ARMs come with these three features, and sometimes a fourth. Here's how they work:
Adjustment intervals. The adjustment schedule is set out in the mortgage contract. Changes in the rate to be charged on an ARM loan occur at the end of each adjustment period. These periods are equal in length and reoccur throughout the loan term. A loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change yearly; a three-year ARM will have an adjustment three years after you get the loan and every three years thereafter.
See Also: Pick the Right Mortgage
Index. Each ARM is tied to an index that moves up and down in tandem with the general movement of interest rates. The index is used to figure the new loan rate for the next adjustment period. The calculation date -- typically one to two months before the anniversary date of the loan -- is set out in the contract.
Adjustment margin. The loan rate and the index rate move up and down together, but they aren't the same. "Margin" is the percentage amount the lender adds to the index rate to get the ARM's interest rate. Look for it in the mortgage contract. The margin amount, commonly one to three percentage points, usually remains constant over the life of a loan. Whatever the margin amount, add it to the index rate at the adjustment anniversary to get a new "adjusted" rate.
Teaser rates. Some ARMs come with a starting rate that's below the fully indexed rate (the index rate plus margin). The teaser rate may last only a short time, sometimes only months, then convert to a fully indexed rate. This can lead to "payment shock" for borrowers who aren't prepared for a significant increase in their monthly payment.
Caps on interest. There are two types of interest-rate caps.
Lifetime caps, required by law on all new ARMs and on assumptions, limit the interest-rate increase over the life of the loan. With a "5% lifetime cap," your rate can't increase more than five percentage points over the initial rate no matter how high the index rate climbs.
Periodic caps limit the interest-rate increase from one adjustment period to the next. For example, your mortgage contract could provide that should the index rate increase four points in one year, your rate could rise only two points. When rates rise rapidly, periodic caps cushion borrowers from overly steep payment hikes between one adjustment period and the next.
Caps on payment. ARMs with payment caps rather than rate caps limit your monthly payment increase at the time of each adjustment, typically to a certain percentage of the previous payment.
They can create negative amortization when rising interest rates would dictate payments higher than the cap permits. The difference in such cases is added to the loan principal, and as a result your indebtedness can actually grow while you think you’re paying off the loan. ARMs with payment caps are rarely offered and should be avoided.
So-called option, “pick-a-payment” or “pay-option” ARMs that were popular during the last real-estate boom often resulted in negative amortization. Each month borrowers could pay their choice of a minimum, interest only, or fully-amortized 15-year or 30-year payment. These, too, have largely disappeared.