Most adjustable rate loans (ARMs) have a low
introductory rate or start rate, some times as much as 5.0% below
the current market rate of a fixed loan. This start rate is usually
good from 1 month to as long as 10 years. As a rule the lower
the start rate is the shorter the time before the loan makes its
first adjustment.
Index
The index of an ARM is the financial instrument that the loan
is "tied" to, or adjusted to. The most common indices
are the 1-Year Treasury Security, LIBOR (London Interbank Offered
Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th
District Cost of Funds (COFI). Each of these indices move up or
down based on conditions of the financial markets.
Margin
The margin is one of the most important aspects of ARMs because
it is added to the index to determine the interest rate that you
pay. The margin added to the index is known as the fully indexed
rate. As an example if the current index value is 5.50% and your
loan has a margin of 2.5%, your fully indexed rate is 8.00%. Margins
on loans range from 1.75% to 3.5% depending on the index and the
amount financed in relation to the property value.
Interim Caps
All adjustable rate loans carry interim caps. Many ARMs have interest
rate caps of six months or a year. There are loans that have interest
rate caps of three years. Interest rate caps are beneficial in
rising interest rate markets, but can also keep your interest
rate higher than the fully indexed rate if rates are falling rapidly.
Payment Caps
Some loans have payment caps instead of interest rate caps. These
loans reduce payment shock in a rising interest rate market, but
can also lead to deferred interest or "negative amortization.”
These loans generally cap your annual payment increases to 7.5%
of the previous payment.
Lifetime Caps
Almost all ARMs have a maximum interest rate or lifetime interest
rate cap. The lifetime cap varies from company to company and
loan to loan. Loans with low lifetime caps usually have higher
margins, and the reverse is also true. Those loans that carry
low margins often have higher lifetime caps.
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