Adjustable Rate Mortgages / The Modern Adjustable Rate Loan

The modern ARM contains features, which eliminate the problems discussed above, and then some. Today, ARM loans generally provide for periodic adjustment that cannot exceed a stated annual or semi-annual adjustment cap. The most common periodic caps are 2% annually or 1% semi-annually. Also, these loans now feature a life-of-loan adjustment cap, usually 6%.

Every ARM loan interest rate is pegged to some widely known index. I’ve already mentioned the 1-year Treasury Constant Maturity Index. Others are used as well. You may hear references to the COFI (pronounced coffee) loan, an ARM based on the Federal Reserve 11th District Cost Of Funds Index. Another is the LIBOR ARM, based on the 6-month London Inter-bank Offering Rate, and so on. Some indices are more stable than others, so speak to your mortgage broker about which loan would be most useful to you. The initial interest rate on your loan may be set somewhat artificially low, but each subsequent adjustment – periodic rate - will be based on the then variable index on which your loan is pegged plus a fixed amount - the margin - established by your lender, as stated in your mortgage note.

Here’s an example:
Your loan has a periodic cap of 2% per year and a life-of-loan cap of 6%. But let’s see what happens if in a given year the index rate for your loan rises 3%. One might presume that the rate on your loan could then be adjusted by the 3%. But no, your annual periodic cap is 2%; so, your rate would be adjusted up by 2% only. Exploring the example further, a rising index rate over reaches a point greater than the 6% life-of-loan cap. In this scenario the life-of-loan adjustment limitation prohibit your interest rate to exceed your original rate + 6%.