How are interest rates determined on an adjustable rate mortgage (ARM)?

There are two phases in the life of an adjustable rate mortgage (ARM). During the first phase, the interest rate is fixed, just as it is on a fixed rate mortgage (FRM). The difference is that on an FRM the rate is fixed for the term of the loan, whereas on an ARM it is fixed for a shorter period. The period ranges from one month to 10 years. At the end of the initial rate period, the ARM rate is adjusted. The adjustment rule is that the new rate will equal the most recent value of a specified interest rate index, plus a margin. (The margin is specified in the note and remains unchanged through the life of the ARM.) For example, if the index is 5% when the initial rate period ends and the margin is 2.75%, the new rate will be 7.75%. The rule, however, is subject to two conditions.

The first condition is that the increase from the previous rate cannot exceed any rate adjustment cap specified in the ARM contract. An adjustment cap, usually 1% or 2% but ranging in some cases up to 5%, limits the size of any interest rate change.

The second condition is that the new rate cannot exceed the contractual maximum rate Maximum rates are usually 5 or 6 percentage points above the initial rate. During the second phase of an ARM’s life, the interest rate is adjusted periodically. This period may or may not be the same as the initial rate period. For example, an ARM with an initial rate period of 5 years might adjust annually after the 5year period ends. It is referred to as a “5/ 1 ARM.” There are also 3/ 1, 7/ 1 and 10/ 1 ARMs. In some cases, the second adjustment period could be a month.

The rate that is quoted on an ARM, by the media and by loan providers, is the initial rate— regardless of how long that rate lasts. When the initial rate period is short, the quoted rate is a poor indication of interest cost to the borrower. The only significance of the initial rate on a monthly ARM, for example, is that this rate may be used to calculate the initial payment. The index plus margin is called the “fully-indexed rate” (FIR). The FIR based on the most recent value of the index at the time the loan is taken out indicates where the ARM rate may go when the initial rate period ends. If the index rate does not change, the FIR will become the ARM rate. For example, assume the initial rate is 4% for 1 year, the fully indexed rate is 7%, and the rate adjusts every year subject to a 1% rate increase cap. If the index value remains the same, the 7% FIR will be reached at the end of the third year.

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