Calculated Mortgage Rates – How are Adjustable Rate Mortgage Interests Calculated?

Adjustable mortgage rates are calculated by adding a margin to the value of some known index.  An index is a measure of the interest paid for some financial instrument or an average of such.  Examples of such indices include Treasury bill interest, certificates of deposit interest, 11^th District Cost of Funds Index (COFI), and the London Interbank Offered Rate Index (LIBOR).  The margin is some fixed value that is added to the value of the index.  Therefore, the formula for calculating the interest rate for an ARM is as follows:

Interest Rate = Index + Margin

For example, suppose your ARM loan is based on a Treasury bill index that is currently at 2.75% and the margin is 3.25%, then the interest rate on your loan is:

2.75% + 3.25% = 6.00%

The calculation above represents the loan’s fully indexed rate.  ARM loans have initial rates, which are referred to as teaser rates that are lower than the fully indexed rates and are designed to lure you in.  Therefore, for the initial period of the loan, which usually lasts a few months, your rate will be whatever the stated teaser is regardless of the index.

ARM loans also have minimum and maximum interest caps.  Those put a lower and upper bound, respectively, on where the interest can go despite of what the index does.  It is highly unadvisable to obtain a loan without a maximum cap that is fixed for the life of the loan.  When getting an adjustable rate mortgage, make sure you can afford to pay the monthly mortgage bills should the interest rate reach that cap.  It is to your advantage, of course, to obtain a loan with the lowest possible maximum and minimum caps.