Adjustable-Rate Mortgage (ARM): Index, Margin and Caps

How an ARM works

The CFPB’s Consumer Handbook on Adjustable-Rate Mortgages (CHARM) defines an ARM as a mortgage whose rate “adjusts” throughout the loan. Under 12 CFR 1026.19(b)(1), lenders must provide this booklet, or a suitable substitute, when the annual percentage rate may increase after closing on a loan secured by your principal dwelling with a term over one year.

An ARM has two phases:

1. Initial period. The initial rate and the initial principal-and-interest payment stay the same for a limited time.
2. Adjustment period. The rate then changes at regular intervals, and the payment can go up or down.

Reading the name. In a 5/1 or 5/6m ARM, the first number is how long the initial rate lasts. The second is how often the rate changes after that. In a 5/6m ARM, the rate stays the same for five years, then may adjust every six months until the loan is paid off.

Index plus margin

After the initial period, your new rate is calculated as:

Index + Margin = Interest rate (subject to caps)

• Index: a measure of interest rates that moves with the market. The CHARM booklet names the U.S. prime rate and the Constant Maturity Treasury (CMT) rate as common indexes. The lender chooses the index when you apply; it generally does not change after closing.
• Margin: the percentage points the lender adds to the index. It is set in your loan agreement and does not change after closing. The CFPB notes that margins can vary a lot between lenders and can be negotiated.
• Fully indexed rate: index plus margin.

Generally, an ARM’s rate is never lower than the margin, according to the CHARM booklet.

Teaser rates. Some loans start below the fully indexed rate. The CHARM booklet gives this example: index 2%, margin 2.5%, so a fully indexed rate of 4.5%, with a teaser rate of 3%. Even if the index does not move, the rate rises from 3% to 4.5% when the teaser ends.

The three kinds of rate caps

Caps limit how far the rate can move. The CFPB describes three:

Some loans have a higher lifetime cap. Some have a different limit on decreases, called a floor. Two lenders can offer the same initial rate with different caps, so compare caps as well as rates.

Reading the AIR table on your Loan Estimate

Page 2 of the Loan Estimate has an Adjustable Interest Rate (AIR) table. The CHARM booklet’s sample shows a 30-year 5/1 ARM of $216,000:

• Index + margin: 1-year CMT + 2.25%
• Initial rate: 3%
• Minimum/maximum rate: 2.25% / 8%
• First change: beginning of the 61st month; then every 12 months
• Limit on changes: 2% at the first change, 2% after

In that sample, the principal-and-interest payment starts at $910.66 and can reach $1,467 in year 8. These are the booklet’s illustrative figures, not offers.

The CHARM booklet also says your servicer tells you the new payment seven to eight months in advance of the first adjustment.

Risks to check before choosing an ARM

• Payment increases. The CFPB says your payment could go up a lot, even double, once the rate starts adjusting.
• Refinancing is not guaranteed. You may not qualify if your home’s value drops or your finances change. See refinancing.
• Points. Paying points on an ARM often lowers the rate only until the end of the initial period, not over the life of the loan.
• Interest-only and payment-option ARMs. Payments rise when the interest-only period ends. A minimum payment can cause negative amortization, where the balance goes up instead of down.
• Conversion option. Some ARMs let you convert to a fixed rate later, possibly for a fee.

Ask the lender to calculate the highest payment you could ever owe and check it against your budget and your debt-to-income ratio.