The Adjustable Rate Mortgage (ARM)

Some ARM home loans come with options to convert them to a fixed rate mortgage based on a pre-determined formula, during a given time period. Example: the 1-year treasury bill adjustable may be converted to a fixed mortgage rate during the first five years on the adjustment date. Meaning, you have the option to convert during the 13th, 25th, 37th, 49th and 61st months of the mortgage loan.

There are several components that go into calculating the adjustable rate of an ARM mortgage.

Index: This is the market derived interest rate which is used as a base to set future rates of the ARM mortgage loan. Depending on the index chosen, the home borrowing rate could be adjusted monthly, quarterly, semi-annually or annually. The index could be pegged to the following: Treasury Bill Rates, The Prime Rate, Libor and 6 month CD. These indexes are usually published in the newspaper.
Margin: This is the spread added to the index to determine the actual rate charged to the mortgage borrower. Example: Index is based on One Year Treasury Bills 3%. The margin is 2%. The mortgage rate the borrower pays is 5%. Rate = Index Rate + Margin
Adjustment Period: This is the duration for which the mortgage interest rate is fixed. If the adjustment period is one year, then the interest rate will remain fixed for one year, after which time it will adjust.
Adjustment Cap: This is the maximum the interest rate can adjust either up or down for each adjustment period. Example: The adjustment cap is 1 point. The index based interest rates since the last adjustment period went up 1.5 points. The most you will be paying would be 1 point due to the cap. 
Lifetime Cap: The maximum mortgage interest rate charged over the duration of the arm mortgage loan. The cap can be as high as 6%. The cap is based on the interest rate from the first year adjustment period. The rate is 5%. The highest the mortgage interest rate can go is 11% (Base Rate + Lifetime Cap). 

Teaser Rate: This is the starting interest rate of the arm adjustable rate mortgage. It is usually referred to as the teaser rate, since it is lower than the fully indexed rate. The initial low mortgage rate is used to attract people. An arm mortgage is ideal for people who intend to stay in their homes for no more than 5 to 7 years. The benefits of an arm are realized at the beginning.

Affordability: If current mortgage rates and housing prices are high, this may be the only home loan option available to you. You may have a better chance of getting the home loan since the lender incorporates the gross monthly income and the monthly loan payment amount to determine how much you qualify. The monthly amount will be less with a lower interest rate so you might qualify for more.

Interest rates have peaked: By going with an adjustable rate mortgage arm at the peak of the interest rate cycle, the successive rates will be lower as interest rates go down. Your monthly home mortgage payments will be lower.

Complicated to understand: Unlike a fixed rate mortgage that is simple to understand, there are many variables that go into calculating adjustable rate mortgage loans.

Interest rates have bottomed out: By going with an adjustable rate mortgage arm at the bottom of the interest rate cycle, successive borrowing rates will likely go higher as interest rates go down. Your monthly mortgage payments will become less affordable.

Uncertainty: If you plan to be at your property for more than 7 years, you will be dealing with the uncertainty associated with an ARM mortgage. After each adjustment period, you will bet getting new mortgage payments.