How
does an ARM work?
It
actually is not as complicated as one would think. It is important
that you understand every Adjustable Rate Mortgage has three major
components. These components are the Margin, Index and Caps. These
three words may not mean a whole lot to you, so let's define them
individually so you can have a better understanding as to what they
mean.
Margin
=

Fixed or Constant

Index
=

Variance,
ever changing

Caps
=

Liability

Margin
+ Index =

Interest
rate

ARM Margin
The Margin is
the fixed or constant portion of your ARM, this part of your Adjustable
Rate Mortgage does not change. It is fixed for the duration of the
loan when you take out an Adjustable. You will always have a Margin
and it remains the same.
ARM Index
The
Index is the everchanging variance to your Adjustable Rate Mortgage.
A few of the typical types of indices are the 11th District Cost of
Funds (COFI), the Monthly Treasury Average,
the One Year Treasury Bill and the Libor index. The Index is a very
important component to your Adjustable because these indices can move
very volatility or very conservatively. By adding your Margin (the
fixed, constant portion) and your Index (the varying portion) together,
you get your interest rate.
So,
to recap, Margin + Index = Interest Rate.
ARM Caps
Beyond
that, we have what are called Caps. These Caps are what we like to
refer to as your liability. Let's give you a specific example of how
one particular Adjustable Rate Mortgage works, and it will allow for
all three components we just defined to become a part of this process.
Let's say that presently you can get an Adjustable Rate Mortgage at
an interest rate of 5%. Your fixed margin is at 2.75% and your adjustable
index is tied to the One Year Treasury Bill, which presently has a
value of 2.50%.
We just determined that Margin + Index (2.75 + 2.50) = Interest
Rate (5.25%). However, your starting interest rate is at 5% on this
loan, which is called your introductory teaser rate. So for the first
12 months your interest rate will be at 5%. Since this Adjustable
Rate Mortgage has an annual adjustment, at the end of the 12month
cycle, the Lender will add your fixed Margin to the varying Index
to get your interest rate for the next 12 months.
So
what if your Margin is 2.75% and the Index increases to 7.5% next
year?
Margin + Index = 2.75% + 7.5% = 10.25%
Will
my rate go that high?" The answer to that question is no, because
that is where the Caps (the liability) kick in.
Caps
protect you from having uncontrolled increases in your Adjustable.
Let's say this particular Adjustable has what is called a 2% annual
and 6% life Cap. What that simply means is, the rate could never go
up more than 2% in any annual adjustment period, nor could it ever
go up more than 6% for the life of the loan. So, referring to the
same example, if you are starting out at 5%, the worst this rate could
ever be is 11%. Regardless of what margin and index add up to, with
your 2% annual Cap the worst it could be next year is 7%.
So even if next year your Margin + Index = 10.25%, your rate would
only go up to 7% because the Cap would kick in and protect you. If
Margin + Index is a factor that is less then 7%, the your interest
rate would adjust to whatever the Margin + Index equals for that adjustment
period.