A type of mortgage where the interest rate that is to be paid on an outstanding balance changes periodically, in relation to an index based on which the interest rate can go up and down accordingly. The interest rate is kept fixed initially for a specific period of time called the “Initial Rate Period”. After the initial rate period, the interest rate may vary based on an interest rate index.
The index and the Margin
The interest rate of an ARM generally consists of two parts:
- Index
- Margin
Index: It is a benchmark interest rate that reflects the present market status. The index amount varies from time to time based on the market and this result in changes in the interest rate.
Margin: The margin is the amount set by the lender and it is a constant value throughout the time period you are liable to pay your interests.
Index + Margin = Interest Rate
How ARM is calculated?
Consider a 5/1 ARM. Here the index is 3.5% and the margin is set as 2.25%
5/1 means that for first 5 years the initial rate of 3.5% index is fixed. Starting from year 6 the interest rates will adjust every year, denoted by the 1.
So for 5 years you will pay a fixed interest of 3.5% + 2.25% = 5.75%
Consider for 6th year the index rate changes to 2.5% then the interest rate will be 4.75% and this change in interest rate will continue every year, until the end of your loan tenure.
NOTE:
Almost all adjustable loans include rate caps that limit the increase in the interest rate for a fixed timeline, due to high raise in the index value.
