Adjustable Rate Mortgage Essential Terminology

Depending on your situation, an adjustable rate mortgage (ARM) or variable mortgage can help you save money and afford a home that would have been prohibitively expensive with a traditional 30-year fixed rate mortgage. But because adjustable rate mortgages are more complex, it is incumbent upon you as the consumer to ensure that you understand the terms and avoid getting roped in by predatory lending tactics.

While most adjustable rate mortgages are designed to best fit your needs, rather than exploit you, it’s still possible to find yourself in an unfavorable situation if you don’t understand the implications of your ARM. As such, it’s important to read through your terms very carefully before signing on the dotted line. But before you do so, make sure you understand some of the technical terms that will be used throughout.

Adjustable Rate Mortgage Definitions

Adjustable Rate Mortgage - A mortgage with an interest rate that can be adjusted (aka recast or recalculated) up or down over time. This differs from a fixed-rate mortgage, which has the same interest rate for the life of the loan.
Adjustment Period - This is the amount of time between adjustments in your interest rate. Adjustment periods can be monthly, quarterly, yearly or longer.
Index - Lenders base interest rates on an index. Most commonly, these are indexes determined by market movements, such as the 1-year constant-maturity Treasury (CMT) securities, the London Interbank Offered Rate (LIBOR) or the Cost of Funds Index (COFI). These are typically published in financial newspapers and online.
Margin - This is the amount that a lender adds on top of the index percentage to determine your interest rate. While your interest rate will fluctuate with an ARM, your margin typically stays the same. For example, if the index rate is 5 percent and your margin is 3 percent, your total interest rate will be 8 percent. This is known as the fully indexed rate.
Discounted Index Rate - Sometimes, lenders will offer introductory rates that are lower than the indexed rate. Sometimes called teaser rates, discounted index rates typically give you few months or years of a low rate until the promotional period ends. At that time, your rate will increase by several percentage points.
Interest-rate caps - An interest rate cap limits how much your interest rate can rise over a period of time or the life of the loan. This is a built-in consumer protection against sharply rising interest rates.
Periodic Adjustment Cap - This limits the amount an interest rate can increase from one adjustment period to the next. For example ,if your periodic adjustment cap is 0.5 percent per year, and the index increases by 1.5 percent, your interest rate will only increase by 0.5 percent. However, the deferred 1.0 percent increase can be applied over the next adjustment period, even if the interest rate does not increase. This is called carryover.
Lifetime Cap - This limits how much your interest rate can increase over the entire life of the loan. For example, if you have a 15-year ARM with a 7 percent interest rate to start and a 6 percent lifetime cap, you will never pay more than 13 percent, even if the index exceeds that rate.
Payment Caps - A payment cap limits how much your monthly payment can be. These are usually expressed as percentages, which can be confusing. For example, a 7.5 percent payment cap on a $1,000 initial monthly payment will prevent your monthly payment from rising above $1,075 during any given adjustment period. However, this does not change how much you owe, rather it only affects your minimum monthly payment to stay out of default. Any unpaid interest simply gets added on to your principle, which can lead to negative amortization, in which your principle grows each month.
Hybrid ARMs - A combination of a fixed-rate and adjustable rate mortgage. For example, a 5/1 ARM would have a fixed interest rate for the first five years. Thereafter, it would adjust every year.

These are the essential terms you should know before comparing and contrasting ARMs. But be on the lookout for more terms that you do not understand. The mortgage industry is continually inventing new terms, rules and products. Be sure that you have a crystal clear understanding of all terms and phrases before moving forward - never assume.