How does an adjustable rate work?

Understanding how an adjustable rate mortgage (ARM) works can help you when shopping for a mortgage. The basic components of an ARM are the INDEX, MARGIN and RATE. In addition to those things, you also need to understand the yearly and life of the loan CAPS. By knowing how your ARM adjusts, when it adjusts and how much it adjusts can help you better shop for the loan that best fits your needs.

Adjustable Rate Mortgages generally have 3 different caps on how much the interest rate can adjust. These caps are often given in a format such as 6/2/6.
The first number is the limit on how much the rate can adjust at the first scheduled adjustment. On a 3 year ARM, this would be at the end of 3 years.
The second number is the cap on how much the rate can adjust on any adjustment period after the initial adjustment period. ARMs usually adjust annually, every 6 months or every month.
The third number is the life of the loan limit. That is the maximum your mortgage can adjust upwards over the life of the loan.
So, 6/2/6 caps on a 3 year ARM with annual adjustment means your rate cannot adjust more than 6% at the end of 3 years, not more than 2% any year after that, and never more than 6% above the initial rate.

INDEX + MARGIN = RATE

The index floats and can go up or down in time. The margin is fixed and is part of your particular mortgage. The resulting rate is the interest rate you pay and thus floats with the index.

The portion of your ARM that adjusts is the index. There are several indexes that adjustable rate mortgages are tied to.

Typically, an ARM will have a fixed period for 2 or 3 years, then will adjust after that.