In an adjustable-rate mortgage, or ARM, the interest rate can change (or adjust) periodically throughout the life of the loan.
Fortunately, the adjustment procedures are built into the note itself; your mortgage rate won't change at the whim of your lender. What are the adjustment procedures? Adjustments are based on the index, margin, adjustment cap, and lifetime cap.
The index is the starting point for how your monthly payments will adjust due to the change in the ARM. The index, or the base point, is tied to a specific number associated with a commonly tracked financial number.
Common indexes are the one-year Treasury note and the London Interbank Offered Rate, or LIBOR. There have been other indexes in the past, but these two are by far the most common.
A margin is the amount, expressed as a percent, that is added to the initial index. Common margins range from 2.00 percent to 2.75 percent.
The adjustment cap is a consumer piece that protects the mortgage rate from wild swings, hampering the borrower's ability to pay the note. After adding the index to the margin, this cap allows for only incremental increases when the rate adjusts. Caps are based on the previous mortgage rate. If the rate for the past year was 5 percent, then that rate can go no higher than the annual cap will allow, regardless of the index.
Caps can also apply when mortgage rates go down. Indexes can go up or down; they don't always have to go up.
The lifetime cap is the mortgage rate's limit over the course of the loan. It is based on the initial starting rate of the adjustable-rate mortgage.
Typically, about 60 days before an adjustable-rate mortgage makes an adjustment — sometimes called a “reset” — the lender will notify the borrower. Adjustment dates can be annual, twice per year, or even monthly. But most ARMs adjust either once or twice per year.
The lender letter will advise you of the index to be used and will add the margin to establish your new rate for the following year, in the case of a one-year ARM, for instance.
If the ARM is based on the one-year Treasury bill, the lender will use the then-current yield for the one-year Treasury. If the index on that day is 3.00 percent, the lender will add the margin of, say, 2.50 percent. By adding the margin and the index together, your rate for the following year will be 3.00 + 2.50 = 5.50 percent. Moving forward, the cap will protect you from wild swings if the index experiences a large increase (or decrease).
For example, say the one-year Treasury bill was indexed at 2 percent, but due to inflationary concerns over the life of the loan (well examine in detail how mortgage rates move in the next section), the one-year Treasury has hit 5 percent.
Now, at the time of adjustment, the lender would take the then-current 5.00 percent rate and add the 2.50 percent margin. The new rate would be 7.50 percent.
However, because the previous year's rate was 4.50 percent, the adjustment cap keeps it from going up no more than 2.00 percent from the previous year's rate. The lender would love the rate to go to 7.50 percent, but due to the cap it can go only to 6.50 percent.
Common lifetime caps are 5 percent or 6 percent. At 5 percent, the highest your rate could ever go would be 10 percent. Even if the one-year Treasury hit 12 percent, your mortgage rate would never go higher than 10 percent, your lifetime cap.