Most adjustable rate mortgages (ARMs) have a low introductory rate or start rate aka the “teaser rate". The start rate is typically in effect from as little as 6 months to as long as 10 years. As a rule, the lower the start rate the shorter the time before the loan makes its first adjustment.
Index
The index is the financial instrument that an adjustable rate mortgage is "tied to" or adjusted to. The most common indices are the 1-Year Treasury Security, The Treasury Average, the LIBOR (London Inter-Bank Offered Rate), the Prime Lending Rate, and the11th District Cost of Funds Index (COFI). Each of these indices can move up or down based on the movement or direction of the financial markets.
Margin
The margin is one of the most important aspects of an ARM because it is added to the index to determine the interest rate that you owe. The margin added to the index is referred to as the “fully indexed rate”. For example, if the current index value is 2.0% and your loan has a margin of 2.5%, your fully indexed rate is 4.50%. Margins typically range from 2.00% to 2.75%, depending on the index used, the quality of the loan application, (including the credit scores), the loan size in relation to the value of the property, etc.
Interim Caps
Many ARMs carry “interim caps” of six months or one year limiting the amount your rate can vary for a specified period of time. Interim interest rate caps are beneficial in rising interest rate markets, but can also keep your interest rate higher than the fully indexed rate, if rates are rapidly falling.
Lifetime Caps
ARMs commonly have a maximum interest rate or “lifetime” interest rate cap. The lifetime cap varies from one loan program to another. Loans offered with low lifetime caps may have higher margins, and the reverse can also be true. An applicant should carefully consider which feature is more important to them based on their particular scenario and how long they believe they will retain the mortgage.