How ARM resets are calculated

With all the news out there of the coming deluge of ARM (Adjustable Rate Mortgage) resets on both conforming and non-conforming loans, I thought it might be a good time to explain how a lender comes up with a new payment when an interest rate adjusts.

First, some terms that you should become familiar with:

Index: This is the base rate to which the new adjusted rate will be based upon.

Some common indexes to base rates on are the U.S. Treasury's and the LIBOR. These indexes change as the markets go up and down.

Margin: This is a fixed amount to be added to the index to calculate the new rate.

In your loan documents this is stated as a number (i.e. 3.00% or 2.50%)
to be added to a specific index. It will also state when the index will be examined for purposes of calculating your new rate, usually 30 to 45 days before the adjustment date.

Caps: These refer to the maximum amount a rate can adjust at any one adjustment and over the course of the loan.

Some common caps are 1/5 (change a maximum of 1% up or down from the current rate during any one change and a maximum of 5% from the original rate), and the 2/6 (change a maximum of 2% up or down from the current rate during any one change and a maximum of 6% up or down from the original rate).

Let me show you an example:

Original Terms of 3 Year ARM

Loan Rate = 7.00%
Margin = 3.00% over the current LIBOR 45 days prior to change date
Cap = 2/6

*Note: That means that at the time of the loan the LIBOR had to be 4.00%
(7.00%-3.00%=4.00%)

Now let's say three years are almost up. 45 days before the new rate will go into effect the LIBOR is at 5.50%

To calculate the new rate you must add the margin to the index
5.50%(LIBOR) + 3.00%(Margin) = 8.50%

But, what would happen if the index had gone up to 6.50% instead.

6.5%(LIBOR) + 3.00%(Margin) = 9.50%
But that is not the new rate.
The loan had a cap of 2/6 so the most the loan rate could increase would be to 9.00%
(7.00% + 2.00% = 9.00%)

What would the highest rate be that this loan can ever have?

7.00% (original rate) + 6.00% (maximum rate per cap) = 13.00%

The same applies when the index falls. What would the new rate be if the LIBOR fell to 1.50%?

1.50%(LIBOR) + 3.00%(Margin) = 4.50%
Again the caps apply. The most the rate can go down in any one adjustment is 2.00% from the previous rate. So the new rate could not be any less than 5.00%
(7.00%(Current rate) - 2.00%(Margin) = 5.00%).

As you can see the calculation is fairly easy addition or subtraction. Hopefully this has taken some of the mystery out of how your new rate is calculated when you have an ARM.

Any questions or comments are always welcome!

Brought to you by Professional Mortgage Group, Inc. in Columbia, Missouri.