You hear a lot about ARMs, but a lot of people still find them confusing. The rate changes, they tell me, but they aren’t sure how. Arms aren’t all that complicated. Today I would like to try to clear up some of the confusion.

An ARM, just like a fixed rate loan, has two elements: The interest rate and monthly payment. With a fixed rate loan those items stay the same. With an ARM, the interest rate changes –and that causes changes in your payment.

Here’s how it works. On your loan there is a period in between rate changes called the adjustment period. A one year ARM has a rate period of one year; so that’s how often the interest rate – and the payment can change. A 3-year ARM has a 3-year adjustment period, and so on. The interest rate has two parts:

• · The index
• · The margin

The index determines the interest rate. It may be based on CMT securities, the Cost of Funds Index (COFI), the London Interbank Offered Rate (LIBOR) or even the lender’s own cost of funds. These indexes vary. Some change more often than others, and some are generally higher than the others. The second part of your interest rate is the margin. That’s how much your interest rate will be over and above the margin. For example, if your index is 3 percent and there is an added 3 percent margin, the rate would be

Index + Margin = Fully Indexed rate

3% + 3% = 6%

If the index rose to 4%, the fully indexed rate would be 7%, and so on. There is a limit, called a cap, on how much your loan can change. In my next post we’ll talk about the interest caps.