Adjustable Rate Mortgages have three main features: Margin, Index, and Caps. The Margin is the fixed portion of the adjustable rate. It remains the same for the duration of the loan. The Index is the variable portion. This is what makes an ARM adjustable. Margin + Index = Interest Rate.

It's important to understand that there are many different indices: the 11th District Cost of Funds (COFI), the Monthly Treasury Average (MTA), the One Year Treasury Bill, the Six Month London Inter-Bank Offering Rates (LIBOR), etc. Each index has its own strengths and weaknesses. Some are slow moving while others are more aggressive.

The third and final component of an Adjustable Rate Mortgages is Caps. Caps limit how much the rate can fluctuate over time. Annual Caps restrict changes to the annual rate, whereas Life Caps provide a worst case scenario over the life of the loan. Some loan programs even have Payment Caps which determine what the minimum payment will be during successive years.

There are many different types of ARMs available, so it’s important to be sure that you have a clear understanding of the benefits and features of any ARM program you’re considering. One ARM that is gaining a lot of attention is the Option ARM.

Option ARMs have been favored by many West Coast savings and loans and are known for their very low start rate. It’s common to see these loans offered at a starting interest rate of 1.00% and, in some, cases even lower. It’s very important to recognize that for an Option ARM, this starting rate is only good for the first month and establishes the minimum payments due for the first year. Beginning with the second month, the interest rate will start to adjust on a monthly basis and will continue to do so every month that the loan is in effect.

Minimum required payments will only change once every twelve months, and typically they will not change by more than 7.5% of the previous year’s minimum required payment. For example, if your minimum required mortgage payment was $1,000 this year, your minimum required payment for next year would not change by more than $75. This annual payment cap will usually be in effect for the first five years of the mortgage.

The reason the loan is referred to as an Option ARM is that the borrower has the choice of making any one of four payment options during a particular month. The first option is to make the minimum required payment, which may be less than the full interest due on the loan. The second option is to make an interest-only payment. The third option is to make a fully-amortizing payment, where you’re paying both principal and interest on the mortgage. The fourth payment option is to make an advance principal payment, where you’re paying the loan at a faster rate than would normally be required.

Each ARM program has its own advantages which can benefit consumers, depending upon their situation. With the right knowledge and circumstances, an ARM can be a good decision for almost everyone.