s are long term mortgages that have periodic interest rate adjustments; ARMs are also known as variable rate mortgages (VRMs). Because ARMs are generally fully amortizing loans, the monthly payments adjust in tangent with the interest rate adjustment to assure that the loan will be paid in full at the end of the loan term. Some ARMs may have an interest rate adjustment, but the monthly payment may not adjust; the difference or "shortfall" in interest may be added to the principal creating a negative amortizing loan. In essence, the principal balance of the loan increase rather than decreases. ARMs have several important features which are detailed below and are generally outlined in the mortgage note:

Index:

The interest rate on ARMs moves in tangent with a short term interest rate index that is published in the Wall Street Journal or another business publication. These indexes can be a bundle or average of many interest rates or they may be specific in nature. Some of the most common indexes are the 1 Year Treasury Security Yield based on a constant maturity CMT, 11th District Average Cost of Funds (COFI) or the London Inter Bank Rate (LIBOR). The indexes move in tangent with other short term interest rate debt instruments.

Margins:

The margin of an ARM is the spread indicated as a percentage that is combined with the index to create the rate of interest on ARMs. The margins remain fixed for the term of the loan and are not impacted by the financial markets and movement of interest rates. Lenders use a variety of margins depending upon the loan program and adjustment periods.

Interest Rate:

The interest rate, also known as the fully indexed rate, is the combination of the index plus the margin.

Adjustment Period:

The interest on ARMs adjusts periodically. The adjustment periods are outline in the mortgage note and remain fixed for the life of the loan. Adjustment periods can range from a month to 7 years. Most ARMs have adjustment periods of 6 months to 1 year. Before the interest adjustment occurs, lenders notify borrowers of payment and interest rate changes.

Periodic Interest Rate Caps:

Most ARMs have caps on the amount of interest rate adjustments within an adjustment period.. Generally, a loan with 6 a month adjustment period will have a cap of 1%, while a 1 year ARM will have, 2% cap. Some lenders do not have an interest rate cap, but have a cap on the payment adjustments. Generally, this type of ARM has interest rate adjustments monthly and payment adjustments annually creating the potential for negative amortization.

Life Cap:

The life cap is the maximum interest rate the ARM may have during the life of the loan. Life caps can vary by lender or investor, but most ARMs have caps of 5% to 6%. Teaser Rate: Many times lenders will offer an introductory rate that is below the fully indexed rate.

Convertible ARMs:

Sometimes lenders may offer a fixed rate conversion feature on an ARM allowing borrowers to convert the loan to a fixed rate mortgage sometime in the future.