Some  ARMs are negative amortizing in that the principal balance of the loan can increase faster than the loan is being paid off through monthly payments.  Usually, these involve shorter  term  loans carrying a balloon balance which will be paid in full at maturity of the balloon.

Important features of ARMs are outlined below:

Index                                                                                                           

Interest rates move in tangent with a short term interest rate index usually published in the Wall Street Journal or other business publication.  Lenders may tie their interest rates on ARMs to either a specific index such as the 1-year  Treasury security yield (based on a constant maturity,)   LIBOR - London Inter Bank Rate, or  the 11th District Cost of Funds (COFI)  or their rates may be tied to a bundle or average of many interest rates or indicators. The indexes usually move in tangent with other debt instruments and interest rate indicators.

Margin

A "margin"  of an ARM is the interest rate "spread"  (expressed as a percentage)  that is combined with the index comprising the rate of interest charged on the  ARM loan.  Margins remain fixed throughout the loan term and are not impacted by interest rate movements in the financial  markets. Lenders use a variety of margins depending upon the loan product and rate adjustment period.

Interest Rate

The interest rate is the combination of the index plus the margin.

Adjustment Period

The adjustment period that designates when the interest rate will be adjusted is outlined in the mortgage note and remains fixed during the life of the loan.  Adjustment periods can vary from a month to 7 years although most  ARMs  adjust about every  6 months to 1 year. 

Lenders are usually required to notify borrowers before payment and interest rate changes occur.

Periodic Interest Rate Caps

ARMs  usually have interest rate "caps" on the amount that the rate may actually change.   Generally, a mortgage  with a  6-month adjustment period has a cap of 1%  while a 1- year ARM usually has a  2% cap. 

Beware of any lenders that do not offer an interest rate cap but only offer a cap on the payment adjustments.  This type of ARM loan has the potential of creating negative amortization.

Life Cap

The "life cap"  is the maximum rate the loan may have over it's life.  Life caps  vary by lender and/or investor although most have caps of 5% to 6%.

Beware of "teaser rates" that a lender may offer as an introductory rate that is below the fully indexed rate.

Convertible ARMS

Some lenders offer convertible ARMs, loans with a convertible feature that allows the borrower to change from an adjustable rate to a fixed rate at some point in the future. 

Some ARMS are retained in the lenders' portfolio and can be an appealing asset because the indexed rate can be structured to interest rates paid on deposits.  ARMs can also be sold in the secondary market as a capital market debt instrument aggregated into mortgage backed securities.  The primary disadvantage to borrowers is the potential of higher future rates.

Considering An ARM?

1. How long will I occupy my home? (If you plan to sell in the next 3 or 4 years, ARMs may be a good option to consider.)
2. Is my income likely to rise if interest rates increase?
3. Can the monthly payments increase even if interest rates do not?
4. Am I anticipating any major expenditures in the future (college tuition or a new car) that will require more borrowing?

Note: When comparing ARMs, look closely at the index and margin and discuss with the lender. Some indexes may have higher average values but could  be used with lower margins. Be sure to compare "like" products.