What You Need to Know About ARMs

When you shop for an adjustable-rate mortgage, or ARM, make sure you understand how these features affect the loan:

Adjustment intervals. With an ARM, the interest rate adjusts periodically throughout the life of the loan. The adjustment schedule is set out in the mortgage contract. A loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change yearly. Hybrid ARMs have an initial period during which the interest rate remains fixed and adjusts annually after that. You'll find 3/1 ARMs (the initial rate is fixed for three years), 5/1 ARMs, 7/1 ARMs, and 10/1 ARMs, as well as 5/5 ARMs (the initial rate is fixed for five years and then adjusts every five years). The longer the initial fixed-rate period, the higher the initial interest rate you will pay and the less advantage the ARM offers over a fixed rate of interest.

Index. Each ARM is tied to an index that moves up and down in tandem with the general movement of interest rates—often the London Interbank Offered Rate (LIBOR). 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.

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Adjustment margin. This 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 a few 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. Under new rules that go into effect in early 2014, lenders who want to make "qualified mortgages" (which protect them from having to buy back failed mortgages from investors and guarantors) must determine whether you can afford the monthly payment based on the fully indexed rate, not just the teaser rate, before they approve you for a loan.

Other Features

Caps on interest. There are two types of interest-rate caps. Lifetime caps 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 say that your rate could rise only two points at each adjustment period--a typical limit—even if the index rate increases, say, four points in one year. When rates rise rapidly, periodic caps cushion borrowers from overly steep payment hikes.

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 (meaning the outstanding mortgage balance increases) 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. The new "qualified mortgage" rules forbid a negative amortization feature.

So-called “option,” “pick-a-payment” or “pay-option” ARMs, which 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.