- An initial fixed period during which the mortgage rate doesn't change
- An initial interest rate that is charged during the initial fixed period
- An index that is used to calculate the new interest rate after an adjustment. An index is a variable and is usually assigned to LIBOR or Treasuries.
- A margin that is a constant added to the index to calculate the new interest rate after an adjustment. Margins vary from 1.500% to 6.999%, depending on the type of mortgage.
- Caps which define the limits by which an ARM can adjust during any given adjustment phase, and during its life. Caps can prevent ARMs from adjusting too far too fast and can vary from 2.000% to 5.000%.
Now that we understand the "parts" of an ARM, we can understand how it works.
ARMs are generally named for their initial fixed rate period. A "5-year ARM", for example, means that the mortgage interest rate will not change for the first five years.
After the initial fixed period, an ARM adjusts to its new interest rate according to the following formula:
(New Interest Rate) = (Index) + (Margin)
So, if the index is LIBOR (which is 4.82% right now) and the margin is 2.250%, the new rate on the adjusting ARM will be 7.07%. The loan will also adjust according to the same formula on every 1-year anniversay thereafter.
Of course, there are variation of ARMs that differ from the one described above, but this definition fits most of them.