How do banks determine ARM rates?

ARM rates & How Does the Bank Calculate My Monthly Payment?

A variable-rate mortgage also known as an adjustable-rate mortgage (ARM), or a tracker mortgage is a mortgage loan which has the interest rate on the note periodically adjusted based on an index that reflects the cost to the lender of borrowing on the credit markets. An adjustable-rate mortgage typically changes based on the market, not your personal financial situation. To calculate your new ARM rates, mortgage lenders take into account two numbers: the index and the margin. Index rate + margin = your ARM rates

ARM: Index

The index is a benchmark interest rate that reflects general market conditions. The index amount changes based on the market, and is maintained by a third party.  It is these changes in the index amount that drive the changes to your interest rate. These indexes usually fluctuate up and down depending on the general movement of interest rates. When the index rate moves up, so does your mortgage rate; however if the index rate goes down, your monthly payment will probably go down as well. Lenders base ARM rates on a variety of indexes. Some of the most used indexes are the prime lending rate, the one-year constant maturity treasury (CMT) value, the one-month, six-month and 12-month LIBORs, as well as the MTA index, which is a 12-month moving average of the one-year CMT index. Another index that lenders use frequently is the national or regional average cost of funds to savings and loan associations. In addition, there are also a few lenders that use their own cost of funds as an index, providing them a stricter control over the rates than if they were using other indexes. When comparing mortgages you should ask what index they are offering and how often it will change. It is always a good idea to check how it has fluctuated in the past so you can get a better idea of what to expect in future ARM rates.

ARM: Margin

The mortgage margin is a fixed percentage that is added to your ARM's index value to determine the mortgage's interest rate. The mortgage margin serves as a fee for providing the mortgage. The margin is constant throughout the life of the mortgage, while the index value is variable. The mortgage margin is the profit that your lender makes on your adjustable rate mortgage. If the prime rate is 4% and the margin is 2%, then the fully index interest rate is 6%. An ARM's margin is a very important part of the loan's interest rate.

Mortgage rates come in eighths

One thing you should be aware of is that mortgage rates move in eighths. In other words, when you have a rate offer, it will either be a whole number, such as 4%, or 4.125%, 4.25%, 4.375%, 4.5%, 4.625%, 4.75%, or 4.875%. The next stop after that is 5%, then the process repeats itself.  In case the advertised rates have other percentages, such as 4.72 or 4.96%, that’s due to the APR that has been factored in the costs of the loan.
Let’s see how indexes and margins work:
If you are shopping for a mortgage, and have an offer of a 7/1 ARM that has an initial rate of 4.5% percent and an adjustable rate of 1 year LIBOR (the index) + 2.5% percent (the margin). In this case, 7/1 means that the initial rate of 4.5% will be fixed for the first 7 years, and the rate will adjust every year starting in year 8. At the beginning of the eighth year of your mortgage loan, your rate will adjust. In case the One-Year LIBOR index has increased to 2.75% at that time. Your new rate will be 5.25%. Here’s how to calcuate: 2.75% (1 yr LIBOR) + 2.5% (margin) = 5.25% (your rate) At the beginning of the ninth year of your mortgage, your rate will recalculate and will adjust every year thereafter. Let’s assume the 1 year LIBOR is now 3.25%.  Your new rate would be 5.75%. 3.25% (LIBOR) + 2.5% (margin) = 5.75% (your rate)

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