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Adjustable rate mortgages or ARMs are chosen by about one third of all loan applicants. Unfortunately, many people do not understand the key components of an ARM or how they are calculated. It is critical to understand the four key components of adjustable rate mortgages when comparing loan offers from various lenders.

In general an ARM starts at one rate of interest and then fluctuates up and down during the period of the loan based on several factors. Knowing and understanding these critical factors will help you in your decision making process when shopping for an adjustable rate mortgage. An ARM can be divided into four basic parts: the index, the margin, the adjustment period, and rate caps.

Every ARM is tied to an index. This index is basically a movement of an objective economic indicator. This index can be anything the lender wants to tie your rate to but it is typically indexed to a 1 year treasury note, prime rate index, Cost Of Funds Index (COFI), or London Interbank Offered Rate (LIBOR). Some of these indexes move up and down slowly and others can change very rapidly. So investigate the history of the different indexes and pay close attention to how often they move and how much. Try to choose an index that moves slowly so your rate and monthly payment remain fairly stable over time. Choosing which index to use with your loan is one of your most important decisions when shopping for a loan.

The margin is another important part of any adjustable rate mortgage. The total interest rate you will pay will be equal to the index rate plus the margin. The margin is a number that the lender will add to the selected index. For example, the lender may specify a margin of 2.25%. so if the selected index is at 4% then the effective mortgage interest rate will be 6.25%.The margin represents the lenders cost of doing business and basically equates to the amount necessary to cover their expenses, overhead, profit, lender defaults and foreclosures. Always look at the margin to make sure it is competitive.

The adjustment period is how frequently the lender can change or adjust your mortgage rate up or down based on the movement of your selected index. An adjustment period could be monthly, quarterly, semi annually, annually, every three years, or every five years. Most common adjustment periods are every six months or annually. On every adjustment period anniversary the lender will look at your index and see if it has changed. At this point they will add your margin to the new index rate and this will be your new effective mortgage interest rate until the next adjustment period. Most of the time the longest adjustment period will be best. The longest one will give you the greatest stability in your rate and monthly payment.

The fourth and last part is rate caps. Lenders use rate caps to show how much of an interest rate change is permitted each adjustment period. A rate cap protects consumers from wild swings in their loan index by limiting the increase from period to period. Without rate caps in a volatile market an index could start at 6% and shoot up to 12% by the end of the adjustment period. But with a rate cap of 3% the rate could not be adjusted more than 3% therefore, the new loan rate would only be adjusted up to 9% not 12%. Remember the rate cap is simply the maximum the lender can change your rate at the adjustment period. In general try to get the smallest rate cap possible when shopping among lenders. Using these four factors when shopping for an adjustable rate mortgage should give you a good idea which ones are more competitive.