Adjustable Rate Mortgages (ARMs) – What You Need To Know

Hearing the words “Adjustable Rate Mortgage” can send some prospective borrowers running for the hills.  But what is an adjustable rate mortgage?  An adjustable rate mortgage is a mortgage whose interest rate is adjusted periodically to reflect market conditions.  You might be thinking: A 30-year loan with an interest rate that can fluctuate over the life of the loan?  If you’re not familiar with the terminology, it can sound scary!  But understanding the terms can help you understand your options better, make a smarter choice, and decide if an adjustable rate mortgage just might be a good fit for you after all. 

The following factors will play an important role in how your loan will work, both today and into the future.  Additionally, the specific numbers you are quoted for each variable can make a big difference in whether or not the loan is truly a good deal.  So what do you need to know?

Initial Interest Rate:  The initial (or sometimes “introductory”) interest rate is the interest rate that you will start out paying on your mortgage. 

Initial Fixed Rate Period:  This refers to a length of time that your initial interest rate is “locked-in” at the beginning of your loan, meaning that it will not change during that time period.  This can vary greatly, so you will want to make sure you ask this.  You may have a period of five years where the rate cannot change, or you may have a period of six months where the rate cannot change.  Knowing how long your rate will remain “fixed” initially can help you plan ahead in terms of budgeting and rule out loans that are not a good fit for you. 

Adjustment Frequency:  After the initial fixed rate period has expired and your loan’s interest rate begins to change, the adjustment frequency will tell you how often to expect a change in your rate.  An adjustment frequency quoted as annually means that, after the initial fixed rate period has expired, each year going forward your interest rate may change according to the economic conditions at that time.  Likewise, an adjustment period of every three years means that your interest rate will be recalculated at three year intervals for the remaining term of your loan.    

Index Rate:  The index rate is a benchmark market value that will be used to calculate each new interest rate on your loan.  Index rates can be based off the value of a single financial instrument (US Treasury Securities) or an average of several financial instruments.  You may be familiar with some index rates, such as the LIBOR (London Inter-Bank Offered Rate) or the Treasury Constant Maturities Index.  When you find out which index is used in calculating your interest rate adjustments, you can research the current index values as well as how stable the rate has been historically. 

Margin:  The margin is a figure set by the financial institution which is also used in calculating each new interest rate.  This is a fixed value that will be added to the index value when calculating the new interest rate. 

Floor (Interest Rate Floor):  This is the lowest value that the rate on your adjustable rate mortgage can ever be.  Depending on the other terms of your loan, it IS possible that your interest rate could adjust downward instead of upward.  Knowing the floor rate on your loan will help you estimate the range of possible payments that you may experience over the life of your ARM.

Ceiling (Interest Rate Ceiling):  The ceiling is the highest value that the interest rate on your adjustable rate mortgage can ever be.  This value will help you calculate your maximum possible payment on your loan, to know whether it would be affordable to you. 

Periodic Cap/Maximum Change (per adjustment):  This value will tell you how much your interest rate can change at any given adjustment.  For example, a maximum change of 2% means that even if market conditions have gone haywire, the most that your interest rate can change is 2% at the next adjustment.  This value helps to safeguard you from skyrocketing interest rates on your mortgage. 

Rounding Factor:  This dictates how the final calculation of your interest rate will be rounded.   It could be rounded up or down, depending on the terms specific to your loan.  The rounded interest rate must be an even multiple of the rounding factor (i.e. for a Rounding Factor of 0.125%, the new rate must be X.00%, X.125%, X.25%, X.375%, X.50%, X.625%, X.75%, or X.875%).

So, now that you know a little of the background information, let's cover how your interest rate actually determined.

Index + Margin = Rate // [Round as required] // Compare to Ceiling, Floor, and Periodic Cap Values

The interest rate on your loan will be calculated by taking the current index rate value, adding the margin, and then rounding it according to the terms of you loan.  Once that value has been determined, the interest rate will be tested compared to the floor, ceiling, and maximum per-change value to ensure that it is within all of those guidelines and limitations.   In other words, the final rate must be higher than or equal to the floor, lower than or equal to the ceiling, and cannot change by more than the periodic cap over the previous interest rate. 

Let’s say that the interest rate on your ARM is currently 3.75%, with a floor of 3.75% and a ceiling of 9.75%.  Using Horizon Community Credit Union’s currently offered loan terms on a 5-1 ARM (fixed for 5 years and adjusting annually thereafter) shown below, the calculation would look like this:

Index Rate: 0.34 (1 Year Treasury Index)

Margin: 3.5

Maximum Increase per Adjustment: 2%

Maximum Decrease per Adjustment: None (meaning that the rate can decrease by any amount)

Rounding Factor: to the nearest 0.125%

The calculation for the new interest rate would then be:

0.34 + 3.5 = 3.84 // Rounded = 3.875

3.875% is greater than the floor, lower than the ceiling, and is less than a 2% increase over the current rate of 3.75%

One final question to ask is what a change in the interest rate will affect.  At Horizon Community Credit Union, a change in the interest rate of your loan will impact your monthly payment amount.  However, other possibilities are the loan term (or the length of the loan), or the amount due at the maturity date of your loan. 

So you see, as long as you do your homework when shopping around, not only getting the starting interest rate but also the variables that will impact your interest rate down the road, you can end up with a great adjustable rate mortgage loan that will fit your needs now and into the future.  

Written By: Cari J.