What is Adjustable Rate Mortgage (ARM)?

In a very simple language, an ARM can be defined as, a mortgage loan that has a variable rate of interest, which is decided on the basis of benchmarks that are set by different economic indexes. The adjustable rate works just like other mortgage loans.

The only difference is that the rate of interest on periodic installments changes the total amount of installments that is to be paid. Usually the first few installments that are paid have a congruent rate of interest. However, according to the promissory note of the ARM, the rate of interest is later on changed, in accordance with the said index.

The rate of interest of such mortgages can be changed as often as every month. The ARM is also known as ‘variable rate mortgage’ or ‘floating rate mortgage’.

What is an Index?

According to the ARM definition, the interest rate that is paid along with every installment of mortgage, is based upon some or the other economic index. In United States of America, there are six primary indexes that are used by the lenders, in order to set the rate of interest on a particular ARM.

  • 11th District Cost of Funds Index
  • London Interbank Offered Rate
  • 12-month Treasury Average Index
  • Bank Bill Swap Rate
  • Constant Maturity Treasury
  • National Average Contract Mortgage Rate

In many western European nations, the adjusted rate is set in accordance with the ECB refinancing rate or Euro Interbank offered rate. Such mortgages are also known as ‘tracker mortgages’. Countries with strong banking systems, commercial/private banks and central banks, have set up a ‘prime lending rate’ which is used by all lenders as index to set the rate of interest. Following the prime rate is easier and advantageous, thus you will find many people sticking to the said rate. This rate is levied onto the borrowers by the way of 3 types of interest adjustments:

  • In some cases, the direct application of index rate, is used. In such a scenario, the exact percentage change in the index is used to modify the rate of interest. For example, if a rise of 3% is observed in the projection of the index, then the rate in interest will also rise by 3%.
  • In some cases that current index rate plus a margin, is levied on the installment. The additional margin is specified in the promissory note, and remains constant throughout the time period of the loan.
  • The third way of levying the rate of interest is with the help of the movement of the index. In this case, the original rate of interest basically keeps on fluctuating and the margin is kept constant.

The adjustable rate indexes, that are followed by mortgage originators, are specified in promissory note. During or before modification of the rate of interest, consumers are informed about the change, and a valid and right proof is given for the change.

How is the Interest on ARM Calculated?

The adjustable mortgage rates, thus basically depends on the type of index that is being followed, and the amount that is payable to the lender. Here’s a small illustration that shall prove to be explanatory…

P = The total amount of your mortgage
N = Number of Years of the mortgage
R = Rate of Interest that is levied initially

Therefore according to the formula of simple interest,

Interest payable for initial period = PNR/100

The P is split into different installments say 48 installments with 12 per year. In the first year, the rate of interest that is applicable is constant. However in the next 3 years it will fluctuate. Therefore, in such a situation the calculation will go as follows…

P1 = P minus principal amount already repaid (does not include the interest that has been paid)
R1 = Rate of interest change according to new index.
N = Number of remaining years

Therefore according to the formula of simple interest,

Interest payable for initial period = P1NR1/100

In case if you are wondering which mortgage to choose, you may consult the guidelines that are issued by government agencies, Federal Reserve Board and Federal Home Loan Bank Board. These agencies have also prepared a mortgage checklist for the buyers and borrowers of mortgage loans, so as to help them to understand the concepts and basics of ARM.