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 rate and payment changes. The period between one rate change and the next is called the “adjustment period.” 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 gives them more control than using other indexes. 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 may 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 and have a loan amount of $65,000. (All the examples used are based on this amount for a 30-year term. Note that the payment amounts shown here do not include taxes, insurance, or similar items.)

Both lenders use the rate on one-year Treasury securities as the 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.

In comparing ARMs, look at both the index and margin for each program. Some indexes have higher values, but they are usually used with lower margins. Be sure to discuss the margin with your lender. A basic example:

	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

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