If you're shopping for a mortgage, and a 6% 30-year fixed rate mortgage (FRM) isn't all that appealing (or maybe it makes your budget too tight), you should investigate adjustable rate mortgages (ARMs) -- especially hybrid ARMs. You'll be in good company: some 30% of all mortgages now being made feature some form of adjustable rate feature. "But I don't like ARMs," you say. "They're confusing, and uncertain, and my payments will go up."

That may not be true -- if you understand how ARMs work, and how to use them to your advantage. We've drafted this simple guide to ARMs to help you to decide whether or not any ARM is for you.

Many ARMs aren't priced or structured for sale in the "secondary market," where loans are pooled together and sold to investors. Because many are put together as "portfolio product", that is, to meet the lender's own needs, there can be much greater flexibility in how they are priced and presented to you. You might also find somewhat more liberal qualifying terms.

The Basics

ARMs are simply short-term fixed rate mortgages. The longer the fixed rate period, the higher the interest rate you'll pay for that period. For example, a one-year ARM generally has a higher interest rate than does a six-month ARM. A true 3-year ARM, where the rate adjusts every three years, has a higher rate than does the one-year variety, and so on.

The starting rate for ARMs is usually priced at a discount from the "index + margin" formula; this "introductory rate" (sometimes called a "teaser rate") is an incentive for you to take the loan. Real "teaser" ARMs, by definition, have a starting interest rate below that of the value of the index which governs the ARM, and are increasingly rare in today's very low rate environment.

ARMs are usually priced at a discount, which is why the starting rate can be less than the sum of the index plus the margin. The discounted rate is an incentive to take a loan with a rate that changes regularly. If not for that discount, it wouldn't make sense to take an ARM when FRM rates aren't much higher.

Indexes

ARMs come in many varieties, but they all work the same way. At the end of the fixed period, the interest rate is changed in accordance with the value of a specified economic indicator, called an index. While there are many indexes used to govern ARMs, the most prevalent types are:

Treasury Constant Maturities (also called Treasury Securities, or TCM): the most common Index; used on one-year ARMs and Hybrid ARMs

Treasury Bills: mostly used for three month and six month ARMs

11th District Cost- of-Funds (also called COFI, pronounced 'coffee'): used mainly on one month and six month ARMs

London InterBank Offered Rate (LIBOR, pronounced 'lye-bore'): used mainly on one month and six month ARMs, some annual ARMs

There are also several other varieties of indexes, including those generated using a so-called ‘moving average' of a number of weekly or monthly values, and those contrived by (and available from) only specific lenders.

When the ARM rate is adjusted, the lender (or servicer) finds the value of the Index, and adds a markup, known as a Margin. Generally, the total of your index plus margin equals the interest rate you'll be charged for the next fixed period, however long that may be.

Caps

To protect you from large rate increases, most ARMs feature some form of limitations on how much your rate can move from fixed period to fixed period. These limitations are called "caps" or "rate caps". You may hear them referred to as "two and six caps"; they may also be called "periodic and lifetime" caps, "per-adjustment and life" caps, and so on. Although many kinds of cap structures are possible, the most common kinds of caps limit your change at any one time to two percentage points, and a total of six percentage points over the life of the loan. In many cases, these caps also restrict how low your rate can go.

For example, if you have a one-year ARM with a 2% per adjustment cap, and you're paying 6%, the worst you might see next year would be 8% (the best, 4%). Your periodic cap limits your increase -- no matter what the index plus margin add up to.

Here's a better example:

You have a one-year ARM at 5.75% for the first year. The year comes to a close. The lender takes the value of the index – for example, 5.25% -- and adds a margin of 2.75% to arrive at your new interest rate. So, your calculation is structured like this: 5.25% + 2.75% = 8.00%

But wait. You have a limit on how much your rate can move at any one time. Your current rate, plus your cap, is the maximum that you can be charged under the terms of your contract:

Current Rate + Current Cap = Maximum New Rate    for this change.

Which calculates as 5.75% + 2.00% = 7.75%    maximum new rate.

Your current interest rate is 5.75%, and your cap (limit) is two percentage points. 5.75% + 2.00% = 7.75% , and your interest rate cannot move any higher than 7.75%, so that's what your new interest rate will become.

What happens to the difference? Except in very rare circumstances, the rest is simply discarded. This is the risk the lender or investor takes in making you an ARM; while his benefit is in the fact that your rate will change with market conditions, he may or may not get the maximum value from his investment dollar.

Some ARMs, such as Hybrid ARMs, have limited (or no) caps to limit movement at the first adjustment. More details can be found in Hybrid ARMs" in Part 2.