Understanding how the lender calculates an adjustable rate mortgage (ARM) is important when considering a home loan. Lenders use various methods to calculate the amount of interest that’s paid by the homeowner. The method that the mortgage server uses can have a substantial impact on the future monthly payments. The interest rate on an ARM is calculated using an index and a margin.
The Adjustable Rate Mortgage Index
The index is one part that lenders use to figure the monthly interest mortgage payment on an ARM. There are several more common indexes that lenders use to calculate the interest payment. The more common indexes are the:
- London Interbank Offered Rate (LIBOR)
- Constant Maturity Treasury Securities (CMT)
- Cost of Funds Index (COFI)
There are also other indexes that the lender can use. It’s important that the homeowner asks the mortgage server what index they use. Although most indexes somewhat follow the current economic conditions, there are some variations for one index to the other. Historical performance of the various indexes may be a good indicator of future performance.
The Adjustable Rate Mortgage Margin
The margin is the other part that lenders use to figure the monthly interest mortgage payment on an ARM. The margin is somewhat of an arbitrary figure that can vary from one mortgage server to another. The margin, unlike the index, usually stays consistent for the life of the loan.
Adding the index to the margin determines the monthly interest rate percentage for an adjustable rate mortgage. Together with the principle payment (not applicable on an interest only ARM) make up the monthly mortgage payment.
- index
- + margin
- + principal (if applicable)
- = monthly payment
Interest Rate Cap on an Adjustable Rate Mortgage Payment
The interest rate cap puts a maximum limit on the amount of interest that can be charged. There are two considerations for an interest rate cap.
- periodic adjustment cap
- lifetime cap
A periodic adjustment cap puts a maximum limit on the percentage of interest that can be charged from one adjustment period to the next. A lifetime cap puts a maximum limit on the interest rate over the life of the loan. If for example the interest rate increases 1% for each periodic adjustment. If the initial rate were 4% with a lifetime cap of 8%, the interest rate would be maxed out after the 4th adjustment.
There are different types of adjustable rate mortgages that can also have an affect on the monthly payments. There are also payment option ARMs that could create negative amortization where unpaid principal is added to monthly future payments. When considering an ARM, it’s best to look at all the options. It’s also important to compare index and margin rates when shopping lenders.
Source:
federalreserve.com
James Clausen - Clausen received a Bachelors Degree in Business Administration in Automotive Management and Marketing at Northwood University, graduating ...
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