Adjustable Rate Mortgage Explained: Index, Margin, Caps and 5/1 ARMs
If you've been reading about adjustable rate mortgage explained in plain terms, you've probably noticed that most explanations skip straight to a name like "5/1 ARM" and assume you know what that means. I'd rather start from the pieces. An adjustable-rate mortgage (ARM) is built from a handful of parts, and once you know them you can read any ARM offer. Whether an ARM is a good idea for you is a separate question, which I cover in fixed vs adjustable rate mortgage.
The Consumer Financial Protection Bureau (CFPB) describes an ARM as a mortgage with an interest rate that changes, or "adjusts," throughout the loan. The rate and payment may start out low, but both can increase quickly. The CFPB's advice is to consider an ARM only if you can afford increases in your monthly payment, even to the maximum amount.
The loan has two phases. First comes an introductory period when the rate stays the same. Then comes a period when the rate resets at regular intervals for the rest of the loan.
What does 5/1 ARM mean?
The first number is how many years your starting rate lasts. The second number is how often the rate can change after that. A 5/1 ARM keeps its rate for five years, then adjusts once a year.
What is the difference between the index and the margin?
The index is a market measure of interest rates that changes over time. The margin is an extra percentage the lender adds to the index. Your rate after the introductory period is the index plus the margin, subject to any caps.
Do all adjustable-rate mortgages have caps?
No. The CFPB says some ARMs set caps, and some also limit how much the rate can decrease. Check the Loan Estimate and the ARM program disclosure for the caps on your loan.
How will I know my payment is changing?
Your servicer notifies you in advance. The CFPB handbook says you get your new payment amount seven to eight months before the first rate change (later changes come with shorter notice, generally 60 to 120 days), and your Loan Estimate shows the highest payment the loan could reach.