Understanding Current Rate Mortgages (ARM) and Why They Change Home buyers who take on an adjustable rate mortgage (ARM) only to be hit later with unexpected costs or rising interest rates can t blame lenders for their troubles. Under current disclosure rules, lenders give every ARM borrower an educational packet that outlines and explains the mechanics of an adjustable rate mortgage. In this article, we ll give you an overview of how adjustable rate mortgages work and how lenders set their rates today. Basically, mortgage interest rates are tied to several indices like the U.S. government securities or the cost of fund rates like a Certificate of Deposit (CD) index, Cost of Funds Index, the London Interbank Offered Rate and others. The adjustable rate mortgages have a varying rate that s linked to those indices. The rate you re initially quoted will be lower than a fixed rate mortgage, but if the economy goes down and inflation begins to rise, your rate could go higher. Essentially, the market risk associated with inflation is passed on to you, the borrower, and not the lender. Lenders will add a small buffer onto the standard index rate, usually 2 to 3 percent. This is the note rate or actual interest rate that you ll be charged. Remember, when you apply for an adjustable rate mortgage or look at rates in their ads, you re seeing the teaser rate which is usually way below standard market values. You need to find out what the “note” rate is to get a true picture of the cost of borrowing. Once the note rate is set, the lender typically offers what s called a cap. There are lifetime caps and annual caps, and these limit the amount that a lender can raise or lower your interest rates. Usually, over a year, it s about 1.5 to 2 percent. The lifetime caps can go as high as 6 to 7 percent, depending on the lender. Remember, that cap is tied to the note rate and not your introductory rate. You also want to find out how often rates can be adjusted. Some lenders will adjust their rates monthly, while others do so annually, quarterly or even once every five years. Ask also about the notification process - will you get a month or two to prepare for the extra expense or will it come as a surprise? Some adjustable rate mortgages have conversion programs that allow you to convert to a fixed mortgage at some point during the term. If interest rates go low, you may also consider refinancing for a permanent fixed-rate loan. For information on practical home ownership preparation recommendations, please visit http://www.home-ownership-preparation.com , a popular site providing great insights concerning home purchase readiness, such as home inspection tools , FHA mortgage rates , and many more!