Adjustment Period. The adjustment of an ARM loan is the period of time between one interest rate and monthly payment change and the next. Some ARM loan have two adjustments, one for the rate, second for the payment. The period is different for each ARM; it may occur once a month, every six months, once a year, or every three years. A loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change once each year. Lenders often have a longer adjustment periods. Because lenders might offer four different types of ARMs, each with a different adjustment period, it is important for the borrower to read the loan documents and understand the adjustment period before the loan documents are cut or signed.

Index and Margin. Most lenders tie ARM interest rate changes to change of an index rate. The only requirements a lender must meet in selecting an interest index are:

-the index control cannot be the lender and
-the index must be readily available to and verifiable by the public.

These indexes usually go up and down with the general movement of interest rates. If the index moves up, so does the interest rate on the loan, meaning the borrower will make higher monthly payments. On the other hand, if interest rate goes down, so the monthly payment.

Lender base ARM rates on a variety of indexes, in fact the index can be almost any index lender selects. Among the most common indexes are 6 month, 3 year or 5 yeear Treasury Securities , T-Bills.; national or regional cost of funds (11th district COFI) and the London InterBank Offering Rate (LIBOR)

To determine interest rate on an ARM, lenders add to the index rate a few percentage points (2 or3), called the margin (also differential or spread)

ARM Rate = Index Rate + Margin

The amount of margin can differ from lender to another, but is always constant over the life of the loan, Loans that have lower loan origination costs tend to have higher margins. Upward adjustments of the ARM interest rate are made at the lender's optio, but downward adjustments are mandatory. On each loan the borrower's terms; including initial rate, caps, index, margin, interest rate change frequency and the payment change frequency, are stated in the same note that accompanies the deed of trust. Terms vary from lender to lender.

ARM Discounts. Some lenders offer initial ARM rates that are lower than the sum of the index and the margin. Such rates, called discounted rate, introductory rates, tickler rates or teaser rates, are usually combined with loan fees (points) and with higher interest rates after the discount expires. Many lenders currently offer introductory rates that are significantly below market interest rates. The discount rates may expire after the first adjustment period (for example after 1 month, 6 months or 1 year). At the end of the introductory discount rate period the ARM interest rate automatically increases to the contract interest rate (index + margin). This can have a substantial increase in the borrower's interest rate and payment.  If the index rate has moved upward, the interest rate and the payment adjustment can be even higher. Even if the index rate has decreased, the borrower's interest rate and monthly payment will likely be adjusted upward at the end of the introductory period.

Many lender use the first year\s payment as the basis for qualifying a borrower for a loan. So even if a lender approves the loan, based on the low introductory rate, it is the borrower's responsibility to determine whether he or she will be able to afford payment is later years, when the discount expires and the rate is adjusted. In fact, this kind of loan subjects the borrower to greater risk, including that of payment shock, which may occur when the payment rises at the first adjustment.

Caps on ARM. Most ARM's have caps that protect borrower from increases in interest rates or monthly payments beyond an amount specified in the note. If loans have no payment cap, borrower might be exposed to unlimited upward adjustments in monthly payments should interest rate rise. Some lenders also allow borrowers to convert an ARM to a fixed rate loan.

Caps vary from lender to lender. The most common are:

A periodic cap: limits the interest rate increase or decrease from one adjustment period to the next. These caps are usually 1% point to 2% point to sometimes 7.5% point of the previous payment amount.

A lifetime cap or overall cap limits the interest rate increase over life of the loan. Assume the introductory rate is 6%, and the first adjustment rate becomes 8%. The overall cap will be attached to the 8%, thus, a 5% cap could mean an interest rate as high as 13%.

An ARM usually has both a periodic and an overall interest rate cap. Some ARMs that have interest rate caps, the monthly payments may increase, even though the index rate has stayed the same or declined.

Because payment caps limit only the amount of payment increases and not interest rate increases, payments sometimes do not cover all of the interest due on a loan. Sometimes called negative amortization, this means the mortgage balance is increasing. The interest shortage in the payment is automatically added to the loan, , and interest may be charged on that amount. The borrower therefore might owe the lender more later in the loan term than at the start. However, an increase in the value of the home might make up for the increase in the amount owed because of negative amortization.

Some loans allow negative amortization but have a cap on the rate of negative amortization possible.

Convertible ARMs. A convertible Arm clause is one that allows borrower to convert ARM to fixed rate loan at designated times. When a borrower converts, the new rate is generally set at the current market rate for fixed rate loans plus at least .375 or 1 % as a servicing premium.

Assumable ARMs. Although the majority of Arms are assumable, lenders normally place conditions on the assumption of the loan. The lender may require that the new borrower supply credit information, complete a credit application, and meet the customary credit standards applied by each lender.

Some lenders allow only one assumption. Other lenders allow assumption but adjust the overall cap or the margin to the rate in affect at the time of assumption. Some lenders allow assumption with the original lifetime cap already in affect.