ARM caps, index and margin: reading an adjustable-rate loan

Index plus margin

The CFPB describes the formula as index plus margin equals your interest rate, subject to any caps.

The index is a market interest rate that moves with general conditions. The lender picks the index when you apply, and it generally does not change after closing.

The margin is a fixed number of percentage points the lender adds to the index. It is set when you apply and stays the same for the life of the loan. The CFPB notes that margins can vary a lot between lenders and that you can negotiate the margin.

At each reset the lender takes the current index value, adds the margin and then applies the caps. The result is your new rate until the next reset.

The three caps

The CFPB describes three kinds:

• Initial adjustment cap. How far the rate can move at the first reset. Commonly two or five percentage points.
• Subsequent adjustment cap. How far it can move at each later reset. Commonly one or two points.
• Lifetime cap. How far it can ever move from the starting rate. Commonly five points, though some loans allow more.

Caps are often written as three numbers, such as 2/1/5 or 5/2/5. Some loans also have a floor, a limit on how far the rate can fall that may differ from the limit on increases.

Where to find the terms

Your Loan Estimate has an Adjustable Interest Rate table on page 2. It shows the index and margin, the initial rate, the minimum and maximum rates, how often the rate changes and the limits on each change. Page 1 shows whether the payment can increase and the highest it could be. The CFPB recommends asking the lender to calculate the highest payment you may ever have on the loan.

Comparing ARMs

Two lenders can offer the same starting rate with very different risks. Compare:

• the margin, since it applies for the life of the loan;
• the caps, especially the initial cap, since a 5-point first jump is very different from a 2-point jump;
• how long the fixed period lasts and how often the rate resets after that; and
• the maximum payment.

The CFPB suggests that even if you expect to move or refinance before the first reset, you should still know how much the rate can change. Plans change, and refinancing depends on rates and your finances at the time.

Who might choose an ARM

An ARM can make sense if you are confident you will sell before the fixed period ends, or if the starting rate is much lower than fixed-rate offers and you could handle the maximum payment. It makes less sense if the maximum payment would strain your budget. The fixed versus adjustable guide covers that choice in more detail.

The bottom line

The starting rate is the first step, not the whole story. Write down the index, margin and caps, run the worst-case path and make sure you could live with the highest payment before choosing an ARM.