Most adjustable rate loans (ARMs) have a low introductory rate or start rate, some times as much as 5.0% below the current market rate of a fixed loan. This start rate is usually good from 1 month to as long as 10 years. As a rule, the lower the start rate is the shorter the time before the loan makes its first adjustment, say Emery Federal Credit Union’s Community Bankers.

Index

The index of an ARM is a published measure of economic conditions usually relative to other financial instruments such as Treasury notes or Treasury bills. Other common indices are the 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI). Each of these indices move up or down based on conditions of the financial markets.

Margin

The margin is one of the most important aspects of ARMs because it is added to the index to determine the interest rate that you pay. The margin added to the index is known as the fully indexed rate. As an example if the current index value is 5.50% and your loan has a margin of 2.5%, your fully indexed rate is 8.00%. Margins on loans range from 1.75% to 3.5% depending on the index and the amount financed in relation to the property value.

Interim Caps

All adjustable rate loans carry interim caps. Many ARMs have interest rate caps of six months or a year. There are loans that have interest rate caps of three years. Interest rate caps are beneficial in rising interest rate markets, but can also keep your interest rate higher than the fully indexed rate if rates are falling rapidly.

Payment Caps

Some loans have payment caps instead of interest rate caps. These loans reduce payment shock in a rising interest rate market, but can allow  deferred interest or “negative amortization”. This means the payment is not sufficient to pay all of the interest due and the unpaid interest is added to the balance of the loan.  These loans generally cap your annual payment increases to 7.5% of the previous payment.

Lifetime Caps

Almost all ARMs have a maximum interest rate or lifetime interest rate cap. The lifetime cap varies from company to company and loan to loan. This is the maximum interest rate that could be charged on your loan.  Loans with low lifetime caps usually have higher margins, and the reverse is also true. Those loans that carry low margins often have higher lifetime caps.

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