If you’re a first time home buyer, one of the things you need to do is shop for a good mortgage rate. Aside from looking for the best lender with the lower rates, it’s also good to know what types of mortgages there are available. One of those mortgages is the ARM or adjustable rate mortgage. This type of mortgage is harder to understand than the fixed rate one simply because your interest rate and monthly amortization could vary over time.

ARM’s may sound very juicy at first because of their low rates, but there’s always a word of caution about them. To understand how ARM’s work, there’s a few things you need to know.

1. Initial rate and payment
– This is what usually catches the attention of home buyers. This rate is what you need to pay for the first few years. However, after the initial period, this rate is subject to change, depending on the ARM’s policy.

2. Adjustment Period – This is what you see before the acronym ARM. For example, is it a 1-year ARM, a 3-year ARM? The number means the number of months or years the bank can again change your rates. After each span of adjustment period, your rates could be different.

3. Index - Your interest rate is affected by two factors, the index and the margin. The index is the general measure of interest rates. The most common indexes are they 1-year constant maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). Ask your bank which index they are using, how much it has fluctuated over the years, and where it is published. The more stable the index is, the less prone to hikes your interest rate will be. This information is also available in newspapers and online.

4. Margin
- The margin is the extra amount the lender adds. This value is usually constant over the life of the loan. A fully indexed rate is equal to the margin plus the index. For example, if the index is 5%, then the margin is 3%, then the fully indexed rate is 8%. Some lenders base the margin on how good your credit score is, another reason to pay your debts on time.

5. Interest-rate caps - This is the limit of how high your interest rate can go. There are two types: the periodic cap and the lifetime cap. The periodic one limits the rates from period to period, while the lifetime has a fixed upper range for the life of the loan.

6. Payment cap – Aside from the interest cap, payment caps are also offered by some lenders. This is a rate where your succeeding payment cannot increase more than that range. For example, if your payment cap is 6%, then your next monthly payment cannot increase more than 6% of your previous amortization.

So these are the things you need to know about ARM’s. Once you’ve gotten yourself familiar with the terms, it’s easier to ask smart questions to your banker and really know what the whole deal is about. Take precaution when considering an ARM. You don’t want to end up paying more than you can afford.

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