Adjustable Rate Mortgages (ARMs)

If an initially lower interest rate and lower monthly payments appeal to you and you are not concerned with potential rate increases, you may want to consider an adjustable rate mortgage. These types of mortgages feature an interest rate that adjusts at specified intervals (i.e. every 3, 5, 7 years) depending on changing market conditions. If interest rates go up, your rate and monthly mortgage payment will also go up. However, if rates go down, your rate and mortgage payment will also go down.

The starting rate for ARMs is generally lower than the rate offered on a standard fixed rate mortgage. With lower initial interest rates, initial monthly payments will be lower, so you may be able to qualify for a larger loan amount.

Adjustable Rate Mortgages have 3 Main Features: Margin, Index, & Caps

Margin
The margin is the fixed or constant portion of your adjustable that never changes. It stays the same for the duration of your loan.

Index
The Index is your variance. This is the portion of your Adjustable Rate Mortgage that makes it an Adjustable. The index can be tied to one of several different types of indices. There is the 11th District Cost of Funds, the Monthly Treasury Average, The One Year Treasury Bill, the Six Month Libor, etc. Each of them has their own strengths and weaknesses as well as rates.

The Margin + Index is what equals the interest rate that you will pay on the loan.

And when it is time for your rate to adjust, it will adjust according to whatever the current rate is on the index that your particular loan is tied to. 

Caps
The third feature of an adjustable rate mortgage is the caps, which I like to refer to as your protection.

Let's use the One Year Treasury bill as an example. The caps on the One Year Treasury mortgage are at 2.0% Annual and 6% Life Cap. What that means is simply this; in any given calendar year the most your rate can go up or down is 2%. The most your rate can go up for the life of the loan is 6% from where you began.

If you started off in this One Year Treasury Bill Adjustable at an interest rate of 5% at the end of twelve months your rate would be due to have its first adjustment. At this time, the Lender will take that fixed Margin (1%) and add it to the current rate of the varying Index to derive your new interest rate. Now, if the Margin + Index = 6.25%, that is what your new rate would be. But if Margin + Index equals 7.5%, you would be exceeding your 2% annual cap and the rate would actually only go up to 7%.

There is your protection. The Cap would kick in and prevent you from going up to 7.5% because that is 2.5% higher than where you were the previous calendar year. Subsequently, the Life Cap protects you over the life of the loan, so the most your rate could ever be on this particular example would be 11%. You started at 5%, you have a 6% life cap and no matter what the margin plus index ever equals, you could never exceed 11%.