True to its name, an adjustable-rate mortgage (ARM) loan has a mortgage rate that will change or adjust over time. This makes it very different from a fixed mortgage, which instead carries the same rate of interest over the entire term or “life” of the loan.
We’ve covered ARM loans many times in the past, and you can learn more about them in this in-depth guide. Today, I’d like to explain how the mortgage rate assigned to an ARM loan gets calculated. We will talk about the index, the margin, and the “fully indexed” rate — three very important factors.
Why it matters: This is an important topic for anyone considering an adjustable mortgage product, because it affects the monthly payments as well as the total amount of interest paid over time.
How an Adjustable Mortgage Rate Gets Calculated
There are two important terms that prospective ARM loan borrowers need to understand. When combined, these two factors determine how the adjustable mortgage rate gets calculated and applied. They are the index and the margin.
The index is a general measurement of interest rates. The indexes most commonly used for ARM loan calculation are: the 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). Chances are, your adjustable mortgage rate will be “tied” to one of these three indexes.
The margin, on the other hand, works sort of like a markup. It’s an extra amount added by the lender, on top of the index mentioned above. Margins vary from one lender to the next, but they usually remain constant (unchanging) over the life of the loan.
The Fully Indexed Rate
Recap: To calculate the mortgage rate on an adjustable (ARM) loan, you would simply combine the index and the margin. The resulting number is known as the “fully indexed rate,” in lender jargon. This is what actually gets applied to your monthly payments.
Here’s the calculation again:
The fully indexed rate is the most important number to you, as a borrower. It determines the size of your monthly payments and the total amount of interest you’ll pay over time. But it also helps to know where it comes from, and how it gets calculated.
The lender should provide you with all of this information when you apply for the loan. In fact, they are required to do so. According to the Federal Reserve’s guide to adjustable-rate mortgages:
“The information [the lender gives you] must include … the index and margin, how your rate will be calculated, how often your rate can change, limits on changes (or caps), an example of how high your monthly payment might go, and other ARM features…”
So that’s how adjustable mortgage rates are calculated. The index plus the margin equals the actual (fully indexed) rate that you pay on the loan. Now let’s look at some actual examples. This will help you comparison shop for the best deal.
Examples of ARM Loan Calculation
Let’s say you obtain rate quotes from two different companies, for a 5/1 adjustable-rate mortgage. Both companies use the same index for ARM calculation, but they have different margins (or “markups”).
- Mortgage Company ‘A’ uses the 1- year Treasury index plus a 2% margin.
- Mortgage Company ‘B’ uses the 1-year Treasury index plus a 3% margin.
Here’s how the rate would be calculated in these scenarios:
- Company ‘A’ offers you an ARM loan of 2.25% (based on the 1-year Treasury index) plus their 2% margin. In this scenario, your initial ARM rate would be calculated as 4.25%.
- Company ‘B’ also uses the 1-year Treasury index of 2.25%, but they add a higher margin of 3%. So the interest rate on your ARM loan would be 5.25%.
Remember, the Index Can Change Over Time
Earlier, I mentioned that the lender’s margin typically stays the same over the life of the loan. For example, if the mortgage company assigns a 2% margin to your ARM loan in the beginning, it will probably remain at 2% for the life of the loan. (This is usually how it works, but always verify to be sure. You need to see it in writing.)
The index is a different story. It can change over time. That’s what makes an adjustable-rate mortgage change over time. For instance, if your ARM loan is tied to the 1-year LIBOR index, and the LIBOR goes up when your first adjustment comes around, your mortgage rate will go up as well. This in turn would lead to higher monthly payments.
The reverse is true as well. If the associated index goes down, your ARM rate could be calculated downward as well — resulting in a lower monthly payment. But not all ARMs adjust downward, so make sure you read all of the information the lender gives you. And ask plenty of questions about how your adjustable mortgage is calculated, and how it can behave over time. It’s critical that you understand these things before taking on an ARM loan.