Understanding Adjustable-Rate Mortgages

Fixed-rate mortgages are fairly straightforward; you get one rate for the lifetime of the loan. Adjustable-rate-mortgages (ARM) are trickier; not only can their rate vary, but the way those variations take place can be very different from one ARM to the next.

Let's dissect a "typical" ARM description, as written below:

First, we have the number of years that the ARM's initial rate is locked before it can start to change. In our example, the 5 means that this loan's rate will not change for the first five years of the loan. If you know you're going to sell your home within a certain number of years, an ARM with an initial fixed rate period that matches that time frame can save you thousands in interest payments. But if your plans change or you're unable to sell you home, you may be forced to refinance or cope with much higher monthly payments.

After the slash, we have the adjustment period, which shows how often your rate can change. The 1 indicates that the rate on this loan can change every one year. If the adjustment period were a 3, your rate could change every three years. Adjustment periods can vary from as little to one month to three or more years; be sure you know what you're getting.

Next we have the index. The index is like a benchmark that your lender will use to help determine how much interest you pay on your loan. It's usually based on the interest rate offered by a large bank or group of banks, a financial exchange, or U.S. Treasury investments.

In this case, our index is the LIBOR, which stands for London InterBank Offered Rate. The LIBOR is the interest rate used by banks when they borrow or lend money through the London international money market. The LIBOR is just one of several indices that are commonly used by lenders when issuing ARMs. Others include:

• Prime rate: This is the rate at which commercial banks lend money to their best, most credit-worthy customers.
• T-Bill: This rate reflects the interest paid to investors who purchase treasury bills from the U.S. government.
• COFI: Pronounced "coffee," this rate is an average of the interest rate paid to bank customers with checking and savings accounts in California, Arizona, and Nevada. The full name of this rate is the 11th District Cost of Funds Index -- hence COFI.
• COSI: COSI stands for Cost of Savings Index, and it's based on the three-month average of the interest rates on a group of federally insured banks.
• CMT: The CMT, or One-Year Constant Maturity Treasury rate, reflects the interest paid to investors on various treasury bills.
• MTA: The MTA, or Monthly Treasury Average index, is a rate that represents the moving average of the CMT (see above) over the past twelve months. Since the MTA is an average of the previous 12 months of the CMT rates, it changes much more gradually than the CMT does.

Whichever of these rate indices your lender uses for your ARM, it's important to remember that it will have changed by the time your initial fixed rate period expires. Some indices change faster and more wildly than others. More stable indices offer greater predictability and less variation, which can be comforting when rates go up, but may blunt the amount that you benefit from falling rates. If you're risk averse, stick with more stable indices, like COFI, COSI, or MTA.

The second thing to remember about your ARM's rate index is that it's just the foundation of the interest rate you'll pay on your loan. The total interest rate on your loan is made up of the rate index and the margin. The margin is the last number in our diagram above.

Let's skip to the end of our diagram and tackle the margin. In our example, the margin is 2.25%. This is the amount that the lender adds to your rate index to come up with your total interest payment. This total is also known as the fully-indexed rate.

Rate Index + Margin = Fully-Indexed Rate

Your margin stays the same through the life of your loan, but when your rate index goes up, so does your fully indexed rate.

Bouncing back to the middle of the description, we see a series of three numbers, divided by slashes: 5/2/5. These numbers are the caps, which show you how much your interest rate can change during the life of your loan. Why three numbers? Because in this example, our loan has three different caps: the first cap, the second cap, and the lifetime cap.

The first cap represents how much your rate can go up or down after your initial fixed rate period expires. In our example, the fixed rate period lasts five years before the rate can adjust. Since our first cap is a 5, our rate can go up or down by 5% during that first adjustment.

The rate doesn't have to change that much, of course. It might change by any amount between zero and five percent, depending on how much the rate's index has changed. But our example ARM can't change by more than five percent during that first adjustment.

The second cap describes the amount the rate can change during subsequent adjustment periods. In our example, the second cap is 2. That means the interest rate can't change more than two percent during subsequent adjustment periods (and remember, since our adjustment period is one year, our rate can only change once per year). Even if the rate's index fund goes up 9%, our interest rate change is capped at 2%.

Does that mean that the rate can continue to increase in 2% increments forever? Or decrease until our fully indexed rate is zero (or even more appealingly, a negative number?) In our example, no. The lifetime cap prevents this.

A loan's lifetime cap is its maximum rate change. In our example, the lifetime cap is 5%. That means that the loan's rate cannot increase by more than 5%. Once it reaches that cap, it cannot continue to increase, even if the rate's index shoots through the roof.

By the same logic, our example loan's rate cannot decrease more than 5% over its lifetime, no matter how far the LIBOR rate drops. Sometimes this limit on the rate's decrease is enough to protect the lender from offering loans that generate no profit (or worse, would force them to pay interest). Other times, the loan's terms will include a floor -- a minimum interest rate, below which the ARM's rate cannot fall.

Our example is a fairly vanilla ARM, but ARMs can come in an endless array of flavors. For further reading, the Federal Reserve offers a very thorough explanation of ARMs, as well as a worksheet to help you compare different ARM products.