Index

• All ARMs have an index. The index is simply the financial benchmark to which your loan's interest rate is tied. The most common is the one-year London Inter-Bank Offered Rate (LIBOR). The ARMs offered by Fannie Mae and Freddie Mac are tied to the LIBOR. This is what moves your interest rate and your payment up and down. If your ARM is a home equity line of credit (HELOC), your loan's index is likely to be the prime rate as reported by the Wall Street Journal. There are other indexes used for mortgages, but your mortgage note specifically tells you which one your mortgage uses.
  
  

Margin

• Your margin is a fixed amount above or below the index your mortgage interest rate uses. HELOCs may have margins that are both positive and negative. Typically, first mortgage notes only have positive margins, making the rate higher than the index. If your margin on your first mortgage is 2.25 percent and the index is 1 percent, you add the index to the margin and have an interest rate of 3.25 percent. If your second mortgage has a margin of -.25 percent, you subtract the margin from the index. If your index is at 4.25 percent, your interest rate would be 4 percent.
  
  

Caps

• Many ARMs have caps, ceilings and floors. These are also disclosed in your mortgage's note. The cap is simply the amount your loan can rise or fall in any one adjustment period. If your cap is 2 percent, your interest rate cannot rise or fall more than 2 percent from its current level. Your ceiling is the maximum amount your rate can rise over the life of the loan. The floor is the maximum amount your rate can fall during the life of the loan. If your cap is 2 percent, your ceiling is 5 percent, your floor is 5 percent, and your current interest rate is 6 percent, the most your loan can move on its next adjustment period is up to 8 percent or down to 4 percent. Over the life of the loan, your interest rate cannot ever exceed 11 percent or fall below 1 percent.
  
  

Adjustment Period

• Some ARMs adjust annually, and others adjust more or less often. This depends on the loan program. Traditional ARMS adjust every 12 months. Hybrid ARMs may have a longer initial fixed-rate period. Three-year, five-year, seven-year and 10-year hybrid ARMs are common. A five-year hybrid ARM locks in the initial interest rate for five years before its adjustment. It then normally adjusts every year after that.