When you're getting a mortgage, you typically have two broad options: fixed rate mortgages, whose rates never change, and adjustable rate mortgages, or ARMs. Adjustable rate mortgages are popular because they allow you to take advantage of falling interest rates without having to refinance. Of course, the downside is that when interest rates rise, so too will the interest rate on your mortgage.
When Rates Change
One of the terms of an ARM describes how often the interest rate on the mortgage resets, such as every month, quarter, year or period of years. For example, your ARM might change the rate once every year to keep up with changes in market conditions. However, within each one-year cycle, the rate won't change. Say you took out the ARM on January 1, 2013. You'll keep the initial rate for one year, and then on January 1, 2014, it will switch to the new market rate. Then, it stays the same for another year before changing again on January 1, 2015.
Interest Rate Index
Each ARM is tied to an interest rate index that's used to figure out your new interest rate. Common indexes include the Cost of Funds Index; the yield of one-year constant maturity U.S. Treasury securities; and the London Interbank Offered Rate Index, or LIBOR. For example, if your mortgage is tied to the LIBOR index and when it's time for an adjustment the LIBOR index has gone down 1 percent, your ARM interest rate will also drop by 1 percent.
Margins Don't Change
The index isn't the only part of your ARM interest rate; you also have to include the margin. The margin is a percentage that gets added to the interest rate index to calculate your interest rate. Your margin is set when you take out the mortgage and depends on your overall creditworthiness as a borrower. However, it won't change for the remainder of the loan no matter what happens to your credit. For example, if you have poor credit when you take out the ARM and therefore have a high margin, it won't come down if your credit score improves over the life of the mortgage.
Caps on Rate Changes
ARMs typically use two different ways of capping the amount the interest rate changes. First, some ARMs use a periodic rate cap, which limits the amount the rate can change for any one adjustment. For example, if your ARM has a 1 percent periodic cap and your current rate is 3.5 percent, when it changes it won't be higher than 4.5 percent or lower than 2.5 percent. The second cap is a lifetime cap, which limits how much the rate can change over the life of the mortgage. For example, if you have a lifetime cap of 3 percent and your initial rate was 3.5 percent, it won't go lower than 0.5 percent or higher than 6.5 percent.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."