ARM rates are calculated from the same components: an index and a margin. The index is a published number that reflects economic conditions and moves up and down over time. According to the Federal Reserve, the most common indexes are the 1-year constant-maturity Treasury (CMT) the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).
The margin is a percentage that the lender adds to the index and is usually between two and five percent. The sum of the index and the margin are added to determine the interest rate, called the fully indexed rate. Thus an ARM based on the 6-month LIBOR index (which was .33 percent in July 2014) with a 3.0 percent margin could be expected to reset to 3.33 percent. However, this rate may be affected by other parameters — rate caps and floors.
Rate caps and floors limit how high or low a mortgage rate can go. The periodic cap restricts the size of the increase when it’s time for the interest rate to reset. The limit for the first adjustment may be higher than the limit for subsequent adjustments — for example, the first periodic cap on a 3/1 ARM might be three percent, and the cap for adjustments in years four through 30 might be two percent.
In addition, ARMs come with lifetime caps, which limit how high the interest rate can go over the life of the loan. These are usually set five or six percent higher than the start rate.
Finally, there are floors, which set the lowest possible rate of the loan. In the example above, the loan’s fully-indexed rate (index plus margin) is 3.33 percent. But if the lender has set a floor of 3.5 percent, that’s as low as the rate will go.