How ARMs Work: The Basic Features
The Adjustment Period
With most ARMs, the interest rate and monthly
payment change every year, every three years, or every five years. However,
some ARMs have more frequent interest and payment changes. The period between
one rate change and the next is called the adjustment period. So, a loan with
an adjustment period of one year is called a one-year ARM, and the interest
rate can change once every year.
The Index
Most lenders tie ARM interest rate changes to
changes in an "index rate." These indexes usually go up and down with the
general movement of interest rates. If the index rate moves up, so does your
mortgage rate in most circumstances, and you will probably have to make higher
monthly payments. On the other hand, if the index rate goes down your monthly
payment may go down.
Lenders base ARM rates on a variety of indexes.
Among the most common indexes are the rates on one-, three-, or five-year
Treasury securities. Another common index is the national or regional average
cost of funds to savings and loan associations. A few lenders use their own
cost of funds as an index, which-unlike other indexes they have some control.
You should ask what index will be used and how often it changes. Also ask how
it has fluctuated in the past and where it is published.
The Margin
To determine the interest rate on an ARM, lenders
add to the index rate a few percentage points called the "margin." The amount
of the margin can differ from one lender to another, but it is usually constant
over the life of the loan.
Index rate + margin =
ARM interest rate
Let's say, for example, that you are comparing
ARMS offered by two different lenders. Both ARMs are for 30 years with a loan
amount of $65,000. (All the examples used in this booklet are based on this
amount for a 30-year term. Note that the payment amounts shown here do not
include items like taxes or insurance.)
Both lenders use the one-year Treasury index. But
the first lender uses a 2% margin, and the second lender uses a 3% margin. Here
is how that difference in the margin would affect your initial monthly payment.
| Home Sale
price: |
$ 85,000 |
| Less down
payment: |
- 20,000 |
| Mortgage
Amount: |
$65,000 |
| Mortgage
term: 30 years |
FIRST LENDER
One-year index = 8%
Margin = 2%
ARM interest rate = 10%
Monthly payment @ 10% = $570.42
SECOND LENDER
One-year index = 8%
Margin = 3%
ARM interest rate = 11 %
Monthly
payment @ 11 % = $619.01 |
In comparing ARMS, look at both the index and
margin for each program. Some indexes have higher average values, but they are
usually used with lower margins. Be sure to discuss the margin with your
lender.
Back to
previous ARM page
Back to types of mortgage loans
For information on fixed-rate mortgages, see:
Fixed-rate mortgage information
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