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Adjustable Rate Mortgage Loans (ARMs)

ARMs Have Significantly Lower Interest Rates
than conventional fixed rate loans. ARM's adjust their rates up or down during a given period. This means that your monthly payment may go up or down during your repayment term.
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Adjustable Rate Mortgage Loans:

Advantages and Disadvantages

  • the big advantage of ARMs is the interest rate — which can be significantly lower than 30-year fixed
  • many consumers select the ARMs when they know they will only remain in the home for three of fewer years
  • homeowners use the ARM when they need to qualify for larger loan amounts
  • ARMs are generally assumable which is a plus when homeowners plan to sell in the near future
  • ARMs rates can decrease in declining interest rate markets making your loan payment even less
  • some ARMs have a convertible feature that allows the borrower to convert the ARM to a fixed-rate mortgage
  • the interest rate can fluctuate which makes it hard to budget your finances
  • in rising interest rate markets, your monthly payment can increase significantly
  • some ARMs allow for negative amortization — where caps prevent recovery of the full cost of the loan
  • convertible features can be expensive and may charge a higher interest rate than current prevailing rates
money saving tip
  • make sure the mortgage loan does not have pre-payment penalties
  • check the convertible feature of the ARM — check conversion rate and cost of conversion
  • ARM rates are calculated by the lender adding a margin to major index — the margin is the bank's profit, try to negotiate this margin down
  • negotiate with the lender on any up-front fees, especially fees for convertibility and that are assumable — you may need to use these features if you plan to move in a few years
  • if you can afford the monthly payment on a 15-year loan, you will pay substantially less money than on the 30-year loan — plus your home will be paid off in half the time — see calculation

  • view our program to help payoff your mortgage in 1/3rd of the time saving you thousands in interest. We offer both quick payoff and accelerated payment programs.

    see how the mortgage payoff plan works
apply online

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Adjustable Rate Mortgage Loans:

ARM Components

The ARM components include the following:

  1. Index:
    the ARM begins with a base number which is tied to an published index that can go up or down.

    Two widely used ARM indexes are the Treasury Rate Index and Cost of Funds Index.

    There is more information below about these index rates and how they are determined

  2. Margin:
    the margin is the additional amount that the lender adds to the index to derive the Interest Rate that is charged for the loan.

    The margin covers the lender's cost and profit. The margin may varies between 1.5 to 3.0 percentage points.

  3. Initial Interest Rate:
    the initial rate is the current prevailing rate at the time that you lock-in your position, which is generally one to three percentage points lower than the prevailing 30-year fixed loan rate.

  4. New Interest rate:
    the adjusted interest rate over the life of the loan.

    New interest rate is calculated at the time of adjustment

    New Interest Rate = index + margin

  5. Adjustment Interval:
    the time between the interest rate is scheduled to change. The ARM can change every six months, annually, every three years, or every five years.

    • an ARM with an adjustment interval of six months is called a 6-month ARM.
    • an ARM with an adjustment interval of 1 year is called an 1-Year ARM.
    • and so forth

    At the time of adjustment, your lender will recalculate your loan payment under the new interest rate and remaining term on the loan.

    For example: let's say that you close on 1-year ARM at 5.5% for 30 years. Your monthly payment during the first year (full 12 months) will be as follows:

    Borrows Amount: $100,000
    Interest Rate 5.5%
    Payment Term 30 Years (360 months)
    Monthly Payments Yr-1 $567.79

    At the end of one year,
    your ARM will adjust and reflect the new interest rate. Your lender will then recalculate your new monthly payment using a 29-year term:

    Borrowed Amount: $100,000.00
    (less) principal paid Yr-1 $1347.09
    New Borrowed Amount $98,652.91
    New Interest Rate 6.0%
    Payment Term 29 Years (548 months)
    Monthly Payments Yr-2 $598.83

  6. Interest Rate Caps:
    interest rate caps protect the consumer in the event that interest rates rise too rapidly. There are lifetime caps and adjustment rate caps. Make sure your understand these caps when finalizing your loan decision.

    Example Life-Time Cap:

    ARM index rate: 4.5%
    ARM margin: 2.5%
    Life-Time Cap: 4%
    Current Interest rate: 7.0% (index rate + margin)

    The ARM index rate has jumped to 8%

    The new interest rate equals 8% + 2.5% = 10.5%
    The life-time cap limits the new interest rate to: 4.5% + 4% = 8.5%

    Example Adjustment Rate Cap:

    ARM index rate: 4.5%
    ARM margin: 2.5%
    Periodic Adjustment Rate Cap: 1%
    Current Interest rate: 7.0% (index rate + margin)

    The ARM index rate has jumped to 6%

    The new interest rate equals 6% + 2.5% = 8.5%
    The adjustment rate cap limits the new interest rate for the adjustment period to:
    4.5% + 1% = 5.5%
    So your new rate will be limited to:
    5.5% + 2.5% = 8.0%

  7. Payment Caps:
    limits the payment amount the consumer needs to pay at time of interest rate adjustments.

    Note: payment caps may not provide enough payment to cover the required interest charges during rising interest rates. Under this condition, the consumer will experience negative amortization — where the interest amount not covered is added to the principal of the mortgage loan.

    Example: if your payment cap limits your monthly payment to $1050 when the true payment should be $1250 due to ARM rate adjustments, the unpaid $200 will be added to the principal mortgage loan balance for later payment.


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Adjustable Rate Mortgage Loans:

Notes on the Index Rate

Two widely used ARM indexes are the Treasury Rate Index and Cost of Funds Index.

Lenders on the East Coast and Mid-West typically use the Treasury Rate Index:

which indices are the weekly or monthly average yields on U.S. Treasury securities. These indexes reflect the state of the economy and are more volatile as they move with the market.

Treasure rate index is reported by the Federal Reserve:

Lenders in the West are more likely to use the Cost of Funds Index:

which is published monthly by the Federal Reserve Bank of San Francisco.

11th District Cost of Funds Indices:


Another widely used index is the LIBOR

LIBOR (London International Bank Offering Rates) as published by the WSJ or Fannie Mae.

More information about the LIBOR index from


You will find that about 80% of all ARMs on the market today use one of the three above indexes.

The other 20% or more ARMs may use a variety of indexes that may include CDs index, PRIME Rate, the lender's own cost of funds, and other.

Make sure you check with your lending institution on the type of index they use.

View current average index rates from
What moves interest rates:


lenders within our network offer
adjustable rate mortgages


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Adjustable Rate Mortgage Loans:

Assumability and Convertibility

An assumability clause allows the seller of the home to transfer the mortgage loan to the homebuyer.

This could be an attractive feature in the sale of a home during high interest markets.

For example:
if your ARM is capped at 1-2 points lower than prevailing ARM rates, your mortgage loan has value.

To illustrate this, let's say that interest rates rise and the prevailing ARM rate is 11%. Your existing ARM rate has risen respectively but has a maximum rate of 9%. You can transfer the 9% capped ARM to the new homebuyer.


This assumability feature can become a selling point in the sale of your home.

Note on the other hand, that interest rate markets have been relatively low since the late-1980s. The new homebuyer can generally find an ARM that is as low or lower than your current ARM. So in low interest rate markets, the assumability clause may not have value.


The convertibility clause allows the borrower to convert their existing ARM over to an prevailing fixed-rate loan.

This may become an exercised feature when interest rates begin to rise rapidly.

The convertibility feature does have its cost, however.

  • your conversion rate on a fixed-rate loan is generally higher than your current ARM rate.
  • lenders may tack on the conversion rate an additional margin as compensation for the convertibility feature. Make sure your read the fine print.

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Adjustable Rate Mortgage Loans:

Other ARM Notes

Teaser Rates:

some lenders will entice borrowers with a teaser rate. Note that at the end of the teaser rate, lenders typically adjust the rate to the maximum amount. Make sure you calculate your monthly payment at the potential maximum rate.


Payment Recalculations:

at each adjustment period, lenders must recalculate your monthly payment at the new rate, remaining term, and existing mortgage balance after all existing payments and pre-payments made on the mortgage loan.

Lenders do make mistakes and overcharge ARM borrowers.


You should double check the banks calculation

to make sure you are not overpaying or underpaying your ARM mortgage. This requires you to calculate your new payment with the new rate (based on prevailing index and lender margin), remaining term and mortgage balance.

Download our amortization worksheet to help you in that calculation: click here

Learn about mortgage auditing services:


Note: The loan information above is general information related to mortgage products and the mortgage lending process. The information does not represent terms of any particular lender. Lenders whom you may work with may offer different product terms. is not a lender. Therefore, we cannot quote rates or guarantee best terms. We refer applicants interested in getting a lending quote to Secure Rights, a licensed mortgage broker representing mulitple lenders.

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