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An index is a money market figure that adjusts with inflation, economic downturns, and other financial fluctuations. One example of a popular index is the LIBOR, or London Interbank Offer Rate - the interest rate that British banks charge each other for borrowed funds. Another is the one year United States Treasury note. Over half of all ARMs are based on this index, which is fairly volatile and prone to follow the fortunes of Wall Street. Others such as LIBOT are a little tamer, less prone to jump or sag with every blip on the money market radar screen.

The margin on a 5/1 ARM, or on any ARM is the figure that is added to the index to determine your interest rate annually during the last 25 years of the mortgage. This figure is added to the index to establish your interest rate for the ensuing year. Today the one year Treasury note index is 4.81. If your margin is 3.5%, your interest rate for the following twelve months would be 8.31%. That may seem high, but keep in mind that the first five years of your mortgage had an interest rate that was probably a quarter to half a percent less than the fixed rate offered to prime customers.

It's a game of chance, really. The bank is getting its interest paid off in the later years of the mortgage. Many people who opt for a 5/1 ARM either plan to refinance it in five years or plan to sell the home and move on. These individuals can take advantage of the reduced rate in the loan's early years and avoid paying the price of the inflated interest rate built into the later years. Those who plan to refinance are betting that interest rates will stay low; those planning to move are betting that the home's value will increase and make the move worthwhile.

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