To understand an ARM, you must have a working knowledge of its components. Those components are:
A financial indicator that rises and falls, based primarily on economic fluctuations. It is usually an indicator and is therefore the basis of all future interest adjustments on the loan. Mortgage lenders currently use a variety of indexes.
A lender's loan cost plus profit. The margin is added to the index to determine the interest rate because the index is the cost of funds and the margin in the lender's cost of doing business plus profit.
The rate during the initial period of the loan, which is sometimes lower than the note rate. This initial interest may be a teaser rate, an unusually low rate to entice buyers and allow them to more readily qualify for the loan.
The actual interest rate charged for a particular loan program.
The interval at which the interest is scheduled to change during the life of the loan (e.g. annually).
Interest Rate Caps
Limit placed on the up-and-down movement of the interest rate, specified per period adjustment and lifetime adjustment (e.g. a cap of 2 and 6 means 2% interest increase maximum per adjustment with a 6% interest increase maximum over the life of the loan).
Occurs when a payment is insufficient to cover the interest on a loan. The shortfall amount is added back onto the principal balance.
The option to change from an ARM to a fixed-rate loan. A conversion fee may be charged.
Interest rate increases in excess of the amount allowed by the caps that can be applied at later interest rate adjustments (a component that most newer ARMs are deleting).