In Part III of this three part series on Adjustable Rate Mortgages (see Adjustable Rate Mortgages Part I and Adjustable Rate Mortgages, Part II), I will discuss how to calculate the fully indexed rate, which is the new rate of your ARM when it adjusts. Once the initial fixed period of the ARM expires, the mortgage calculates a new interest rate by adding the index of a mortgage to the margin. I will discuss details of both the index and margin in a bit, but let’s remember that this new rate cannot exceed the caps of the ARM, which were discussed in Part II.

To calculate the new interest rate of an ARM, you simply add two variables together and round up to the nearest .125% interest rate.  These two variables are the loan’s index and margin.

MARGIN

The Margin is a fixed number determined at the beginning of the loan.  This figure never changes.  For example, most conventional Fannie Mae and Freddie Mac ARM’s use a margin of 2.25%.  On FHA and VA ARM’s, the margin usually ranges from 1.75%-2.25%.

INDEX

The index is a market rate that adjusts to market conditions.  The value of an index may not change for months or it can change every day depending on the nature of the index.  Researching the history of each index will help you understand the risk associated with a particular ARM.  Here is a list of the common indexes used for Adjustable Rate Mortgages

6-Month LIBOR (London Inter-Bank Offered Rate)

This index isn’t used as often anymore.  The 6-month LIBOR was a popular index used for many conventional/subprime mortgages.  It may still be used today but isn’t as common as other indexes.

1-year LIBOR

The 1-year LIBOR is the most popular index used today for conventional mortgages.  Most Fannie Mae and Freddie Mac mortgages use the 1-year LIBOR as the index.  The 1-year LIBOR is also used for FHA and VA ARM’s at times.

1-year CMT (Constant Maturity Treasury)

The 1-year CMT is an index primarily used for government backed ARM’s like FHA or VA ARM’s.  Since FHA and VA use both the 1-year CMT and the 1-year LIBOR, it’s important to evaluate which index is associated with every loan FHA or VA loan quote you receive.

Prime Rate

The US Prime Rate is directly affected by the Fed Funds rate you may see mentioned in news articles.  It is the only index that moves exactly to the amount the Fed Funds Rate.  The Prime Rate is always 3% higher than the Fed Funds Rate.   At the time of this posting, the Fed Funds Rate is currently at .25% and the US Prime Rate is at 3.25% respectively.  This index is most commonly used for Home Equity Lines of Credit and some adjustable rate credit cards.

HOW DIFFERENT TWO ADJUSTABLE RATE LOANS CAN BE

Studying the fixed rate period, caps, margin and index of an ARM will help you better understand the total risk associated with a particular adjustable rate loan.  To best illustrate the risk factors of adjustable rate mortgages, I will give an example of two mortgages (Mortgage A and Mortgage B). They appear similar at first glance but are very different after a closer look.

Mortgage A– This is what lenders called a traditional sub-prime adjustable rate loan.  Here are the details:

5.5% initial rate

2 year fixed initial period/ adjusts every 6 months after

6-month LIBOR Index

5/2/5 Caps

5% margin

Mortgage B– This is a traditional FHA 3/1 ARM.  Here are the details:

5.5% initial rate

3- year fixed initial period/ adjusts every 12 months after

1-year CMT Index

1/1/5 cap’s

1.75% margin

At first glance, you will notice the initial interest rates are the same.  Mortgage A is scheduled to be fixed for 2 years vs. 3 years for Mortgage B.  Already B is looking a little safer since the rate will not adjust for a full year after Mortgage A. However, the real difference takes place when we compare the caps, margin and index.

Let’s Compare Them

In Mortgage A, the value of the 6-month LIBOR is 4.5963% in January 2008.  To calculate the new rate, we will add this figure to the margin of 5%.

4.5963% + 5% = 9.5963%

We then round up to the nearest .125%, which is 9.625%.  If your adjustable rate loan was similar to Mortgage A and was set to first adjust on January 2008, the above figures would apply to you.

The initial interest rate adjustment is 5%, which means we cannot exceed 5% above the initial rate.  Below is our cap rate

5.5% (initial rate) + 5% (Initial cap)= 10.5%

This means our “Fully Indexed” rate is less than the cap rate.  In this scenario, your new rate would be 9.625%

Let’s do a similar scenario using Mortgage B.  In January of 2008, the 1-year CMT was at 2.71%.  To calculate the new rate, we will add this figure to the margin of 1.75%.

2.71% + 1.75% = 4.46%

Like Mortgage A, we will round up to the nearest .125% which is 4.5%.  If your adjustable rate loan was like Mortgage B, then this new rate would apply to you.

For Mortgage B, the Initial cap is 1%.  This keeps the rate from moving more than 1%.  If the Index were higher, your max rate on the first adjustment would be the following:

5.5% (initial rate) + 1% (Initial cap) = 6.5%

As you can see, Mortgage B is substantially safer than Mortgage A.  The rate is fixed one year longer than Mortgage A. If Mortgage B were to adjust the same time as Mortgage A the rate would’ve gone down 1% versus going up 4.125%.  In the scenario that both indexes were high enough for each loan to reach the cap rate for the initial adjustment, the increase for Mortgage B is only 1% vs 5% for Mortgage A.

Conclusion

Deciding if an Adjustable Rate Loan is right for you should only be done after you’ve evaluated all of the coherent risks associated with each available mortgage.  I hope this three part series was educational.  You can also read more from a book published by the Federal Reserve titled the “Consumer’s Handbook on Adjustable Rate Mortgages” (called the CHARM booklet for short).