Adjustable Rate Mortgage: Understanding Indexes, Margins and Caps

The Consumer Financial Protection Bureau (CFPB) recommends comparing quotes from competing mortgage lenders when shopping for fixed or adjustable rate mortgages (ARMs). However, comparing ARM loans can be a little more complicated – they have more "moving parts" than fixed home loans. You'll need to understand how adjustable mortgage rates are calculated, when they can change and how much they can change. You'll also need to understand the caps that limit how high the rate can go. Here's an overview of how adjustable mortgage rates work.

The Beginning: Introductory Rates

All ARM loans come with an introductory rate, also called a "start rate" or "teaser rate." This rate is significantly lower than that of fixed-rate mortgages, and it serves as an incentive to get borrowers to accept a variable interest rate. The introductory rate can remain in effect for one month to ten years, depending on the program. A 5/1 ARM, for example, has an introductory rate that is fixed for five years and then resets every year after that.

Once the introductory period end, the interest rate adjusts according to the loan's terms.

ARM Indexes and Margins

Adjustable mortgage rates are calculated by adding a margin to an index. The margin is negotiated between the borrower and the lender, while the index is a published financial measurement – the Dow Jones Industrial Average is one example of an index. In mortgage lending, lenders use different indexes with varying results for adjustable rate mortgage quotes. The One-year Constant Maturity Treasury (CMT), the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR, which is probably the most popular index) are examples of rate indexes used to determine adjustable mortgage rates. They are easy to find online.

Index readings change in response to financial and economic news. Adjustable mortgage rates are calculated by adding the loan's predetermined margin to the index value. This result called the "fully-indexed rate." However, that's not the entire deal. ARMs also come with caps that limit how high the interest rate can go at any one adjustment, and also over the life of the loan. This protects borrowers from extreme payment shocks.

Mortgage Rate Caps

There are three kinds of rate caps:

  • Initial adjustment caps, which limit how high an interest rate can go at its first adjustment.
  • Periodic adjustment caps, which limit how much the rate can increase at subsequent adjustments.
  • Lifetime caps, which limit how high a rate can go over the entire life of the loan.

Here's how a typical ARM might work. Miss Evans has a 5/1 LIBOR ARM with these characteristics:

  • Start rate: 2.5 percent
  • Initial adjustment cap: 3.0 percent
  • Margin: 3.0 percent
  • Periodic adjustment cap: 2.0 percent

If her loan was taken out five years ago, it's going to adjust beginning in Year Six. If that were happening today, the calculation would look like this:

  • The one-year LIBOR rate is .246 percent
  • Adding the 3.0 percent margin to the index provides a fully-indexed rate of 3.246 percent. But that's not the end – the lender has to apply the initial adjustment cap of three percent.
  • The 2.5 percent start rate plus the initial adjustment cap (3.0 percent) equals 5.5 percent. Because the fully-indexed rate of 3.246 percent is lower, it requires no adjustment. The rate for the next year will be 3.246 percent. If the LIBOR was higher, say four percent, the fully-indexed rate would be seven percent. In that case, the cap would apply, and the rate would be 5.5 percent.

Tips for Success

  • Pay attention to your time frame. If you plan to keep a home for about five years, you might save a lot of money by choosing a 5/1 ARM instead of a 30-year fixed loan. The rate would be about one percent lower.
  • Heed your instincts. If you're uncomfortable with ARM mortgages, go with a fixed rate loan.
  • Your lender should issue written disclosures that cover the amount and timing of rate adjustments. Make sure you get these.
  • Don't sign loan papers until you are completely satisfied with your mortgage lender and adjustable rate mortgage terms.

Adjustable rate mortgages can be a great choice, especially if you get a good deal on your loan. The best way to find a great loan is by comparing mortgage rates and terms from competing lenders.

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