How are ARM rates calculated?

By Sabrina Karl

Adjustable rate mortgages, or ARMs, can be attractive for homebuyers who don’t expect to stay in their house for the long haul or who think interest rates will be lower in the future. But since plans often change, and rates are virtually impossible to predict, it’s important to understand how ARM rates adjust.

Each ARM has an initial period and an adjustment period. The initial period is typically 3, 5, 7 or 10 years during which the rate is fixed. But after that, the rate will change according to its adjustment period. For example, a 5/1 ARM will remain fixed for five years, then adjust every year after that.

Two terms in an ARM’s fine print tell you how the new rate will be calculated: the index and the margin. The index is a market benchmark to which your rate is formally pegged. Many ARMs use the 12-month LIBOR index, but there are several others. Each ARM will name the index with which it is linked, and that index will fluctuate with market conditions.

The margin, on the other hand, is fixed and serves as an add-on to the index. So if an ARM’s margin is 3%, and the 12-month LIBOR index is 2.25% at adjustment time, the new rate would be 5.25% (2.25% index + 3% margin).

Two more ARM terms can also come into play. One is the rate adjustment cap, which limits how much the rate can move with any one adjustment. The other is the maximum rate, which specifies the very highest it can rise over the life of the loan.

Anyone considering an ARM will want to carefully compare different products according to index and margin rates, as well as adjustment caps and maximums, as digging into these details can help differentiate between otherwise similar-seeming ARMs.