The adjustable rate mortgage, commonly referred to as an ARM, continues to be a popular choice for borrowers in today's market. In fact, more than half of my clients choose an Arm over a fixed rate mortgage. However, most potential borrowers don't truly understand how ARMs work. With any major financial decision, I always advise to make an educated decision. This article should give you the necessary information to understand the basics of ARMs so when choosing your next mortgage you feel knowledgeable.

An ARM is a mortgage where your interest rate is fixed for a period of time before being able to adjust up or down once the fixed period has passed. After the fixed period there is an adjustment period where the interest rate can adjust every time that adjustment period comes along. For example: A 5/1 ARM means the interest rate is fixed for the first five years and then the interest rate can adjust every year afterwards. A 3/6 ARM is fixed for the first three years and then can adjust every 6 months afterwards. Most of your ARMs will either adjust every year or six months after the initial fixed period. So your 3/1, 5/1, 7/1, and 10/1 ARMs all adjust every year after their initial fixed period. But your 3/6, 5/6, 7/6, and 10/6 ARMs all adjust every 6 months after their initial fixed period. When your loan officer says "Five six ARM", that means fixed for five years and adjusting every six months afterwards.

When it comes to the point where your ARM will adjust it all depends on the index your ARM follows and the adjustment terms. Most ARMs either follow the one of libor indexes or treasury indexes. There are many types of indices; for the sake of this article we will use the six month libor index. The six month libor index is now at 3.840%. Most ARMs will also have a margin above the index (2.25% is a common margin). When calculating your interest rate at the time of adjustment we use the current index the ARM follows plus the margin. So currently someone with a six month libor ARM would be at 6.09% (3.840% index plus 2.25% margin). Now is where the adjustment terms come in.

The two most common adjustment terms for ARMs are 6/2/6 (six two six) or 5/2/5 (five two five). Let us use an example to understand the adjustment terms. A borrower has a 5/1 6/2/6 six month libor ARM. We now know that this means the interest rate is fixed for five years and adjusts every year afterwards based upon the current six month libor index. Now the first part of the 6/2/6 (the six) means that when the five year fixed period is up, the first interest rate adjustment can be up or down a full six percent. Right away you can see how quickly your interest rate can change on the first adjustment period. The second part of the 6/2/6 (the two) means that every adjustment period after the first one can adjust up or down only a maximum of two percent. The last part of the 6/2/6 (the second six) is the life cap, meaning the interest rate can never reach higher than six percent over the start rate. So if a borrower has a 5/1 ARM with 6/2/6 adjustment terms starting at 5.25%, the interest rate can never go above 11.25% for the life of the loan. Real assuring!

This is a lot of information condensed into a very short article. If you still aren't clear on the basics of ARMs I encourage you to call your loan officer and get a more detailed explanation. How many of you have ARMs and don't fully understand the details of the way your loan works? Please work with someone who empowers you with the knowledge to help you make the proper financial decisions.