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More About ARMs

Adjustables are more complicated to evaluate and select than fixed-rate mortgages are. In addition to understanding points and other loan fees on fixed-rate loans, you'll also be bombarded with such jargon as margins, caps, and indexes.

Unlike with a fixed-rate mortgage, precisely determining the amount of money a particular ARM is going to cost you is not possible. As with choosing a home to buy, selecting an ARM that meets your needs and budget involves compromising and deciding what's important to you. So here's your crash course in understanding ARMs.

Where an ARM's interest rate comes from:

  • Most ARMs start at an artificially low interest rate. Selecting an ARM based on this rate is likely to be a huge mistake because you won't be paying this low rate for long, perhaps for just six to twelve months. Lenders and mortgage brokers are like many other salespeople; they like to promote something that will catch your attention and get you thinking you're going to get a great deal. That's why lenders and brokers are most likely to tell you first about the low teaser rate.
  • The starting rate on an ARM is not anywhere near as important as what the future interest rate is going to be on the loan. How the future interest rate on an ARM is determined is the single most important feature for you to understand when evaluating an ARM.
  • All ARMs are based on an equation that includes an index and margin, the two of which are added together to determine and set the future interest rate on the loan.

Before we go further, please be sure that you understand these terms:

  • Index: The index is a measure of interest rates that the lender uses as a reference. For example, the six-month bank certificate of deposit index is used as a reference for many mortgages. Suppose that the going rate on six-month CDs is approximately 5 percent. The index theoretically indicates how much it costs the bank to take in money that it can then lend.
  • Margin: The margin is the lenders' profit (or markup) on the money that they intend to lend. Most loans have margins of around 2.5 percent, but the exact margin depends on the lender and the index that lender is using. When you compare loans that are tied to the same index and are otherwise the same, the loan with the lower margin is better (lower cost) for you.
  • Interest rate: The interest rate is the sum of the index and the margin. It is what you will pay (subject to certain limitations) on your loan.
  • Index + margin = interest rate: Putting it all together, in our example of the six-month CD index at 5 percent, plus a margin of 2.5 percent, we get an interest rate sum of 7.5 percent. This figure is known as the fully indexed rate. If this loan starts out at 5 percent, for example, the fully indexed rate tells you what interest rate this ARM would increase to if the market level of interest rates, as measured by the CD index, stays constant. Never take an ARM unless you understand this important concept of the fully indexed rate.

Many mortgage lenders know that more than a few borrowers focus on an ARM's initial interest rate and ignore the margin and the index that determine the loan rate. Take our advice and look at an ARM's starting rate last. Begin to evaluate an ARM by understanding what index it is tied to and what margin it has.