Adjustable Rate Mortgages – A Detailed Anatomy

There are reasons to choose an adjustable rate mortgage (A.R.M.). A large amount of borrowers do not have a complete understanding of this type of loan. This may be based upon inexperience, lack of a detailed explanation, bad press, or other factors relied upon in the decision making process.

There are times when an adjustable rate mortgage may be your best home financing choice.This will depend on your situation.

Some of these reasons are listed below:

  • You expect to sell your home within a few years.
  • Your income is increasing and you need a lower initial payment to qualify. An FHA adjustable rate mortgage uses the start rate for qualification purposes.
  • You are planning to pay more toward the mortgage principal to pay off your loan faster.
  • You have additional household income but it can not be used to qualify.

An adjustable rate mortgage tends to have a lower overall rate than a fixed rate mortgage because it is much easier to project profit margins.

When a bank gives you a fixed rate mortgage they are assuming that the loan will be profitable over a period of time. This mortgage may cease to be profitable if market conditions change, especially the inflation index. The rate is higher on a fixed rate mortgage to hedge against this occurrence.

Let’s use a loaf of bread as an example of this logic:

You loan a friend a dollar when bread costs 90 cents a loaf. Your friend promises to pay you back $1.10.  When he pays you back the bread costs $1.20 a loaf. The dollar you loaned out is more valuable than the money returned to you. You actually took a loss although you received more money. This is the effect of inflation. You would need to charge a higher rate of return to reduce you chances of taking a loss because you are guessing the value of the returned dollar.

Now let’s use the same example in relation to an adjustable rate:

You loan a friend a dollar. He promised to pay you back 10 cent profit, but the profit will be adjusted for inflation.  Since bread went up 30 cents, you will receive $1.40 back. In this example you could charge less because the guesswork for inflation is gone. An adjustable rate mortgage limits the guesswork for a projected profit so the rate of return initially charged can be less. If the price of bread stayed the same or went down, you would actually pay back less!

An ARM has five major components. They are a floor, ceiling, caps, margin, and index.

The floor is the lowest rate and the ceiling is the highest rate that can be charged on your mortgage when it adjusts. The caps are limits on the adjustment for any period of time. Caps are set to avoid payment shock or large payment increases.

The margin is simply the profit margin that will be set. This is a fixed amount and it will never change. This number is added to the index to derive your rate adjustment.

The index is the component that will actually adjust. The index must be readily available and easily found to be fair. If everyone agreed upon how many apples are in a barrel then this could be an index.

Banks use standard indexes that are published daily. They most widely used are the LIBOR, Treasury, COFI, and Prime.

  • The LIBOR stands for London Interbank Offered Rate. This is a daily reference rate based on the rates at which banks borrow unsecured funds from other banks in the London wholesale money market.
  • The Constant Maturing Treasury (CMT or Treasury) is a United States Treasury security or government debt issued by the United States Department of the Treasury.
  • The COFI or Cost of Funds Index is a regional average of interest expenses incurred by financial institutions. This is mostly based on the 11th district Federal Home Loan Bank (San Francisco CA).
  • Prime indicates the rate of interest at which banks lend to favored customers with high credibility. These are usually large corporations.

Always remember that the margin plus the index equals your new adjusted rate, but it can not adjust below the floor or above the ceiling. It also can not adjust beyond what the caps allow for any given period of time. It’s that simple.

Your choice of the security of a fixed rate or the flexibility of an A.R.M. will depend on your individual circumstances.

Contact me at 732-207-8434 or email

for the lowest rates and fast, reliable service!

Knowing all details will help you make a fully informed decision.


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