Understanding how the lender calculates an adjustable rate mortgage (ARM) is important when considering a home loan. Lenders use various methods to calculate the amount of interest that’s paid by the homeowner. The meth od that the mortgage server uses can have a substantial impact on the future monthly payments. The interest rate on an ARM is calculated using an index and a margin.
The Adjustable Rate Mortgage Index
The index is one part that lenders use to figure the monthly interest mortgage payment on an ARM. There are several more common indexes that lenders use to calculate the interest payment. The more common indexes are the:
- London Interbank Offered Rate (LIBOR)
- Constant Maturity Treasury Securities (CMT)
- Cost of Funds Index (COFI)
The Adjustable Rate Mortgage Margin
The margin is the other part that lenders use to figure the monthly interest mortgage payment on an ARM. The margin is somewhat of an arbitrary figure that can vary from one mortgage server to another. The margin, unlike the index, usually stays consistent for the life of the
Adding the index to the margin determines the monthly interest rate percentage for an adjustable rate mortgage. Together with the principle payment (not applicable on an interest only ARM) make up the monthly mortgage payment.
- + margin
- + principal (if applicable)
- = monthly payment
Interest Rate Cap on an Adjustable Rate Mortgage Payment
The interest rate cap puts a maximum limit on the amount of interest that can be charged. There are two considerations for an interest rate cap.
- periodic adjustment cap
- lifetime cap
There are different types of adjustable rate mortgages that can also have an affect on the monthly payments. There are also payment option ARMs that could create negative amortization where unpaid principal is added to monthly future payments. When considering an ARM, it’s best to look at all the options. It’s also important to compare index and margin rates when shopping lenders.