What impacts the interest rate of an ARM?

An ARM is an adjustable rate mortgage. There are several aspects of ARMs that impact interest rates including:

• Index
• Margin
• Interim caps
• Payment caps  

Index

The index is the financial instrument that the loan is "tied" to, or adjusted to. The most common indices, or, indexes are the 1-Year Treasury Security, LIBOR (London Interbank Offered Rate), Prime, 6-Month Certificate of Deposit (CD) and the 11th District Cost of Funds (COFI). These move up and down dorectly based on conditions of the market.

Margin

This is one of the most important parts of ARMs because it is added to the index to determine the interest rate that you pay. The margin added to the index is known as the fully indexed rate.

Interim Caps

All ARMs carry interim caps. Many ARMs have interest rate caps of six-months or a year. There are loans that have interest rate caps of three years. Interest rate caps are good with rising interest rates, but can also keep your interest rate higher than the fully indexed rate if the interest rates are falling rapidly in the market.

Payment Caps

You can have a payment caps instead of interest rate caps. These loans usually cap your annual payment increases to 7.5% of the previous payment on your mortgage.

Lifetime Caps

Almost all ARMs have a maximum interest rate or lifetime cap. Loans with low lifetime caps usually have higher margins. Then the loans that carry low margins often have higher lifetime caps.