Adjustable-rate mortgages, as the name suggests, are mortgages that do not have a fixed interest rate. Instead, the interest rate changes, or adjusts, at fixed intervals based on the market interest rate.

If you are in the market for a mortgage and are considering an adjustable-rate, make sure you understand the terms and what they mean to how much you’ll pay.

Though it can be intimidating at first, here is an explanation of the lingo surrounding adjustable-rate mortgages:

• Initial rate: basically an introductory interest rate that is fixed for a given period of time at the beginning of the mortgage. During this introductory period, the adjustable-rate mortgage does not adjust. The initial rate can remain in effect for a wide range of time, from as little as a month to five years or more, and during this time payments also remain fixed.
• Adjustment period: how often the mortgage’s interest rate is updated after the initial rate period. For instance, a 1 year adjustable-rate mortgage (ARM) can have a change in the interest rate and payment once every year.
• Index: the measure that the mortgage lender is using to adjust the interest rate on the ARM. Indexes can vary and because the index choice affects the interest rate the ARM charges, investigating what index an ARM uses is very important.
• Margin: though the index is used to adjust the interest rate on the ARM, a mortgage lender does not lend money at cost. The margin is the amount, in addition to the index, the ARM will charge as interest. The margin amount is fixed for the loan, so any fluctuation in interest rate still comes from the index.
• As an example, if the margin on a loan is 3.5% and the index is at 5%, the ARM’s current interest rate would be 8.5%. If the index rises to 6%, when the ARM’s adjustment period comes, the interest rate would increase to 9.5%.
• Rate caps: a rate cap, or interest rate cap, places a limit on the amount the interest rate of the ARM can change. There are two kinds of interest rate caps:
• Periodic adjustment caps: limits the amount the interest rate can change from one adjustment period to the next. The periodic adjustment cap does not apply to the first adjustment, however, made after the initial rate period ends.
• Lifetime caps: create a maximum amount the interest rate of the ARM can ever increase.
• Carryover: an effect of periodic adjustment caps, where the ARM interest rate increases more than the index. This is best illustrated by an example.
  

Assume a margin of 3% and a periodic adjustment cap on the ARM of 2.5%. The index rate was at 4%, so the ARM was charging 7% interest (the index rate plus margin).

Now, the index rate has risen 7% and the adjustment period on the ARM arrives. Without a periodic adjustment cap, the new interest rate on the ARM would be 10% (the new 7% index rate plus the constant 3% margin); however, because of the periodic adjustment cap the interest rate cannot increase to 10% from 7% because it exceeds the limit of 2.5%. Instead, the interest rate could only increase by 2.5% to 9.5% - the cap reduced the interest rate by 0.5% in this case.

However, this is not the end of the story. If at the next adjustment period, the index rate is still at 7%, the ARM’s interest rate still changes. That’s right, even though there is no change in index – the only measure that normally affects the interest rate charged – the rate increases by 0.5% to 10%. This additional 0.5% has been carried-over from the last adjustment period when it could not be applied to the rate because of the adjustment cap.

• Payment caps: like interest rate caps, payment caps limit the amount the payment amount of an ARM can increase from any adjustment period to the next, excluding the first adjustment period. The limitation is a percentage amount, for instance, 8%.
• Negative amortization: payment caps are not without a cost. If the ARM payment should have increased more than the payment cap allowed, the difference between the amounts can actually be added to the principal of the mortgage. This is referred to as negative amortization. In certain instances, negative amortization can actually lead to the balance of an ARM being greater than the original amount of the loan despite timely payments.