You hear that you can get a lower interest rate if you take an adjustable rate mortgage (ARM) so you jump on the chance. But do you know how the ARM loan works? Are you aware of how the index and margin affect your future payments?
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Keep reading to learn about these important terms so that you can fully understand how the ARM loan works.
The ARM Index
Each lender has their own requirements regarding which index they use for an ARM. The most common choices include:
- Prime rate
- 1-Year T-Bill
Of course, each lender can use any index they choose. You should know the chosen index so that you can look at its historical patterns. While you can’t predict what the index will do moving forward, you can see its increases and decreases throughout the past few years to give yourself a decent idea of what to expect.
The index is the base of your ARM rate. The lender then adds the pre-determined margin to the current index rate at the time of your adjustment.
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The margin is the one factor in the ARM rate that doesn’t change. The margin your lender assigns to your loan is the margin for the life of the loan. Lenders often base your margin on your level of risk. If you are risky, you can expect a higher margin than if you were a low risk of default.
Let’s say a lender assigns a 2% margin to your loan. This means that you’d add 2% to the current index rate at the time that your rate adjusts.
How an ARM Loan Works
Now that you understand the index and margin, let’s look at how the ARM loan works. At first, you’ll get the low interest rate that the lender quotes you. Let’s say you can get a 4% interest rate if you take an ARM loan versus a 4.5% rate on a fixed rate loan.
You will notice that the ARM has a number, such as 3/1 or 5/1. The first number signifies the number of years you can enjoy the low introductory rate. In these examples, you’d have a fixed rate for 3 or 5 years. The next number is the frequency at which the rate changes after the first anniversary date change.
Let’s say you have a 3/1 ARM. After three years, the rate will adjust one time per year according to the chosen index plus your predetermined margin. You won’t be able to predict your interest rate by any means, but you can keep an eye on your index to see what it’s doing. If you don’t want to deal with a changing interest rate, you can always refinance out of the ARM before your first rate change. There’s no penalty for doing so.
The index and margin on your ARM loan play an important role in your loan. You should know these numbers and see how they may affect your interest rate. It’s a good idea to ask any potential lender what the worst-case scenario is for your ARM rate. Each loan has caps or maximum amounts the rate can change so a lender can tell you the highest your payment could ever be should the index get to that point. This way you can plan accordingly.