To understand an ARM, you must have a working knowledge of its components. Those components are:
Index: A financial indicator that rises and falls, based primarily on economic fluctuations. It is usually an indicator and is therefore the basis of all future interest adjustments on the loan. Mortgage lenders currently use a variety of indexes.
Margin: A lender's loan cost plus profit. The margin is added to the index to determine the interest rate because the index is the cost of funds and the margin is the lender's cost of doing business plus profit.
Note Rate: The interest rate charged for the fixed period of the ARM, typically 3, 5, 7 or 10 years.
Adjustment Period: The interval at which the rate is scheduled to change during the life of the loan (e.g. annually). For example if you have a 7/1 ARM, the rate is fixed for 7 years and the rate will adjust once a year, every year, after 7 years.
Interest Rate Caps: Limit placed on the up-and-down movement of the interest rate, specified per period adjustment and lifetime adjustment (e.g. a cap of 2 and 6 means 2% interest increase maximum per adjustment with a 6% interest increase maximum over the life of the loan).
Negative Amortization: Occurs when a payment is insufficient to cover the interest on a loan. The shortfall amount is added back onto the principal balance.