ARM is a mortgage loan where the interest rate on the note is periodically adjusted based on an index. Payments made by the borrower may change over time with the changing interest rate. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. The borrower benefits if the interest rate falls and loses out if interest rates rise.

Interest rate = index + margin

Index

The interest rate of adjustable rate mortgages is tied to an index. Some common indexes are:

• 11th District Cost of Funds Index (COFI)
• London Interbank Offered Rate (LIBOR)
• 12-month Treasury Average Index (MTA)
• Constant Maturity Treasury (CMT)
• National Average Contract Mortgage Rate
• Bank Bill Swap Rate (BBSW)

Margin

The margin is specified in the note and remains fixed over the life of the loan. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 3%, 3% being the margin and LIBOR being the index.

Loan Caps

Loan caps provide payment protection against payment shock, and allow a measure of interest rate certainty to those who gamble with initial fixed rates on ARM loans. There are three types of Caps on a typical First Lien Adjustable Rate Mortgage or First Lien Hybrid Adjustable Rate Mortgage.

• Initial Adjustment Rate Cap: The majority of loans have a higher cap for initial adjustments that's indexed to the initial fixed period. In other words, the longer the initial fixed term, the more the bank would like to potentially adjust your loan. Typically, this cap is 2-3% above the Start Rate on a loan with an initial fixed rate term of 3 years or lower and 5-6% above the Start Rate on a loan with an initial fixed rate term of 5 years or greater.
• Rate Adjustment Cap: This is the maximum amount by which an Adjustable Rate Mortgage may increase on each successive adjustment. Similar to the initial cap, this cap is usually 1% above the Start Rate for loans with an initial fixed term of 3 years or greater and usually 2% above the Start Rate for loans that have an initial fixed term of 5 years or greater
• Lifetime Cap: Most First Mortgage loans have a 5% or 6% Life Cap above the Start Rate (this ultimately varies by the lender and credit grade).