How an ARM works:

An ARM is a loan program that has a fluctuating interest rate. This type of loan begins at a low rate of interest and will adjust every six months or every year. The rate of adjustment is based on the index plus margin. The margin is established by the lender and it can be anywhere from 0% to 3% (or more). The margin is set and does not change for the life of the loan. What changes is the index.

An index is a rate recognized by financial markets and published by a neutral party. Below are descriptions of some of the most common indexes used:

11th District Cost of Funds Index (COFI): This index is a weighted average of the interest that banks pay on money they borrow which is mainly from customer's checking and savings accounts. If you have ever examined the interest rate you have on your savings account, you know that the rate moves slowly. The same is with this index, it moves up and down at a slow pace.

Monthly Treasury Average (MTA or MAT): Just as the name reflects, this index is based on the 12 month treasury average. These rates also move slowly.

London Interbank Offered Rate (LIBOR): LIBOR is the rate that London banks pay to borrow money. This index fluctuates more than the COFI and MTA/MAT.

To find out about additional indexes such as the CODI, COSI, and others, visit http://mortgage-x.com/general/indexes/.

Let's say you were to get an ARM based on the MTA index and the lender gives you a margin of 2.3, your rate would be as follows:

2.347 (MTA index) + 2.3 = 4.647%

Types of ARMs

There are many types of ARM programs available. For example, you may have heard the term, "5/1 ARM". What this means is that the interest rate is fixed for 5 years and then adjusts every year after. There are ARMs fixed for 6 months, 1 year, 3 years, 5 years and 7 years.

Another feature that many ARMs have is an interest only option. Each month you can make the principal plus interest payment or just a payment on the interest. For example, if you had a loan balance of $200,000 and you had a 5.5% interest rate, the interest only payment would be $916.67 ($200,000 multiplied by 5.5%, then divided by 12 months).

There is also the Option ARM that gives even more choices each month. An Option ARM is also commonly referred to as COFI, COSI, or Pick a Payment loan. With an Option ARM, you have an initial start rate that is fixed for 1 or 3 months. After that initial period, each month you are given four different payment options: a minimum payment, interest only, 15-year amortizing payment or 30-year amortizing payment. This type of loan program is great for someone who needs a flexible monthly payment. Here is an example of what the monthly options would look like:

Based on loan balance of $200,000, start rate 1%, MTA index and 2.3% margin:

Fully Indexed Rate: 4.647% (index + margin)

Minimum Payment: $643.28

Interest Only Payment: $774.50

30-Year Amortizing Payment: $1,030.91 (includes principal + interest)

15-Year Amortizing Payment: $1,545.05 (includes principal + interest)

An ARM is attractive for many reasons. The interest rates on these loans are lower than the standard 15-year and 30-year mortgage rates. An ARM also allows a borrower to qualify for a higher priced home because the payments are lower. The average person moves or refinances his or her home every five years, so an ARM tends to be good option for savings. However, there is some risk associated with these programs. The interest rates can fluctuate, so if rates rise in the future, so will the ARM payment.

Be sure to consult with your mortgage broker to find out if an ARM is right for you.