As interest rates rise, it's more crucial than ever that you understand how your adjustable rate mortgage (ARM) works or you'll be in the dark about how much your monthly mortgage payment can jump.

If you don't know how high your monthly payment can go, you can't adequately prepare for the greater expense.

Ultimately, that knowledge gap can cost you your home.

The Federal Reserve Board's "Do Homeowners Know Their House Values And Mortgage Terms?" recently revealed:

• Twenty-eight percent of home owners with ARMs can't identify the interest rate index to which rate adjustments are tagged.

• Thirty-five percent of them don't know how much the rate could increase at one time.

• Forty-one percent don't know their mortgage interest rate's potential maximum.

• Twenty percent don't even know what their starting interest rate was when the loan originated.

The study also said low-income and less-educated homeowners are more likely to misunderstand the terms of their ARMs and more and more of those borrowers have landed homes in recent years thanks to the extra leverage ARMs offer.

About a third of all mortgages issued were ARMs in 2004 and 2005, compared with an average of about one-quarter in the 1990s, according to the Mortgage Bankers Association. In regions with the highest home prices, ARMs are the primary home purchase financing tool.

The growth in the use of the loans is a direct market response to the growing cost of home ownership.

Through the 1990s, year-over-year home price appreciation nationwide ranged from about 1 percent to 6 percent, according to the Office of Federal Housing Enterprise Oversight.

By the third quarter of 2004 that rate had more than doubled to 13.02 percent. Since 1990, the highest rate of home price appreciation occurred during the second quarter of 2005, when annual home price appreciation nationwide hit a record 14.13 percent, OFHEO reported.

More recently, rising interest rates have contributed to the exodus out of the FRM market and into ARMs.

ARMs roll back the month-to-month cost of owning a home because they come with terms offering an initial rate that's typically lower than the rate for a fixed-rate mortgage (FRM).

The lower initial rate reduces the monthly payment which can allow a borrower to afford a home that may have been out of reach with a FRM. ARMs' lower initial rate also allows borrowers to stretch financially and buy a larger home or a home in a more desirable neighborhood they perhaps couldn't afford with a FRM's higher monthly payment.

Devil in the details

But the initial rate is just that -- initial. Depending upon the loan, the initial rate can last one month to 10 years. Ultimately, however, other loan terms, impacted by market conditions, can cause the initial rate to rise and with it your monthly mortgage payment.

If you don't know those other terms, you won't know in advance how to budget for an increased mortgage payment.

ARM rates are tied to a fluctuating index -- commonly, the weekly constant maturity yield on the one-year Treasury Bill; the 11th District Cost of Funds Index or COFI; and the London Interbank Offered Rate or LIBOR, but there are others.

Home equity loan ARMs, for example, can be tied to the Wall Street Journal Prime rate, a consensus rate based on a survey of the nation's 30 largest banks.

To determine the ARM rate you pay, the lender adds a market-based margin (typically two or more percentage points) to the index.

While the margin typically remains the same, the index doesn't. As goes the index so goes your mortgage rate and, along with the higher rate, your monthly mortgage payment increases.

Most LIBOR rates and the WSJ Prime are two percentage points higher today than they were a year ago; the one-year Treasury Bill is up about 1.5 percentage points and the COFI has risen a bit more than one percentage point, according to BankRate.com's Rate Watch Report..

How fast your interest rate will actually rise also depends upon other ARM terms including "adjustment periods" and "caps."

The adjustment period is the time between one rate change and the next, typically once every one, three or five years, but more frequently with some ARMs. So-called "Hybrid" ARMs have a single adjustment period, typically after one, three, five, seven or 10 years and then effectively become FRMs with a locked in interest rate for the rest of the loan's term.

In any case, each adjustment period comes with a periodic interest-rate cap, a limit on the amount your interest rate can increase during each adjustment period.

Another cap, the overall or maximum cap, puts a ceiling on the interest rate over the life of the loan.

ARM details, the index used, adjustment periods, interest rate caps and other terms are all spelled out in your loan documents.

If you don't understand the terms, press your broker or lender to explain your specific loan terms by example, say, by penciling out what your mortgage payment could be from one adjustment period to the next, based on a variety of interest rate scenarios from starting rate to rate cap levels.

Outside assistance is also often available at no cost from housing, finance, community and social groups.

Volatile economic conditions that cause indexes to fluctuate prevent you from predicting exactly how much your interest rate will change each adjustment period or over the life of your mortgage, but knowledge of the index, interest rate limits and the inner workings of your ARM will give you a hand up in preparing for the worst.

Ignorance is not a defensible argument in a foreclosure proceeding.

Published: March 31, 2006

Use of this article without permission is a violation of federal copyright laws.

Broderick Perkins parlayed a career in old-school journalism into a contemporary digital news service that really hits home. The award-winning consumer journalist, originally from Wilmington, DE, is founder, publisher and executive editor of the bootstrap DeadlineNews Group, a Silicon Valley-based editorial content and consulting service specializing in residential real estate, consumer news and related editorial consulting services. The DeadlineNews Group includes the website, DeadlineNews.com, offering real estate editorial content and consulting services, and its back shop, the Deadline Newsroom, an open house on news that really hits home. Perkins obtained his formal journalism education from University of Delaware and a journalism boot camp, the Institute of Journalism Education at the University of California-Berkeley. He went on to 20 years of service as a daily newspaper journalist at the Wilmington, DE News Journal and San Jose, CA Mercury News. Perkins covered housing on the San Jose Mercury News reporting team which earned a General News Reporting Pulitzer Prize in 1989 for coverage of the Loma Prieta earthquake. He has also produced real estate, consumer and small business content for the Wall Street Journal, Los Angeles Times, RealtyTimes.com, Nolo.com, Better Homes and Gardens, the National Association of Realtors, Homestore/Move and Intuit/Quicken among more than three dozen publications. In addition to managing the DeadlineNews Group, Perkins most recently served as chief editorial consultant for Nolo's Essential Guide To Buying Your First Home, Nolo, and writes real estate television scripts for RealtyTimes.com.