Adjustable Rate Mortgages (ARM)s are loans whose interest rate can vary during the loan's term. These loans usually have a fixed interest rate for an initial period of time and then can adjust based on current market conditions. The initial rate on an ARM maybe lower than on a fixed rate mortgage but it's not always. Adjustable rate mortgages are usually amortized over a period of 30 years with the initial rate being fixed for anywhere from 3, 5, 7, or 10 years.
ARM loans have a "margin" plus an "index." Margins are the amount (expressed as a percentage) added on top of the index. While the index is the financial instrument which drives the base rate for the loan. Common indexes are LIBOR (London Interbank Offered Rate), Prime, and the 11th District Cost of Funds (COFI).
When the time comes for the ARM to adjust, the margin will be added to the index and typically rounded to the nearest 1/8 of one percent to arrive at the new interest rate. That rate will then be fixed for the next adjustment period. This adjustment can occur every year, but there are factors limiting how much the rates can adjust. These factors are called "caps". Suppose you had a "3/1 ARM" with an initial cap of 2%, a lifetime cap of 6%, and initial interest rate of 6.25%. The highest rate you could have in the fourth year would be 8.25%, and the highest rate you could have during the life of the loan would be 12.25%.