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People opt for ARMs for a number of reasons: some cannot qualify for a fixed rate loan; others use the low initial interest rate on an ARM to qualify for a bigger mortgage than they would with a fixed interest rate. The reasoning behind this phenomenon is that lenders look at a borrower's total debt service as a percentage of his/her income and set a ceiling on how much debt is acceptable. With an artificially low interest rate, the borrower can claim lower debt service at the time the mortgage is drawn up.

ARMs are available with different lengths attached to the initial phase. The standard options are one year, three years, five years, seven years or ten years - after which the rate is adjusted annually. The shorthand for these loans is, respectively, 1/1; 3/1; 5/1; 7/1 and 10/1. The shorter the initial time period, the lower the initial rate will be. For instance, if the same loan is available with an 8% fixed rate, the beginning rate on a 5/1 ARM might be 7.6% and on a 10/1 the rate might be 7.75%.

In an ARM's second phase when the rates are adjusted annually, the yearly interest rate is arrived at by combining an index and a margin. The index is an interest amount taken from one of several widely known money markets: examples include the one year Treasury bill, COFI (the Federal Reserve cost of funds index) and LIBOR (London InterTAN Offer Rate, the amount that British banks charge one another for loans). Different indexes have different properties. The one year T-bill is somewhat volatile, following the ups and downs of the stock market closely. LIBOR is a more stable index, less likely to move in either direction.

The margin is the number of percentage points that will be added to the index on the loan to arrive at an interest rate. Usually this is 2.5 to 3 percentage points and is a figure stipulated in the mortgage agreement. Thus if your index is at 5% on adjustment day and your margin is 2.75%, your interest rate for the year will be 7.75%

Most ARMs have adjustment rate caps. Usually the cap is one or two percentage points. On a 10/1 ARM, the cap on the initial increase may be as much as 5% and drop thereafter to an annual cap of one or two percent. Most ARMs also have a maximum allowable rate, which is usually five or six points above the initial rate. The annual adjustment will be the lowest of the following: the fully indexed rate (index plus margin); the annual cap; or the maximum allowable rate.

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