Adjustable Rate Mortgage (ARM)

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 =
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 ever-changing 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 12-month 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.



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