When you shop for a home mortgage loan, there are so many options it can be overwhelming. There are two basic forms of home loan interest rates, fixed rate loans and adjustable rate loans. Adjustable rate mortgages, or ARMs, are mortgages that have set interest rates for a certain period, but can change or adjust after that period has passed.
All ARMs have an adjustment period, which is the period before or between interest rate changes. With a 7/1 ARM, also known as a seven-year ARM, the adjustment period is seven years. That means that for seven years the interest rate will be set at whatever the pre-agreed rate is. After the seven-year period, the interest rate will be adjusted one time per year based on certain market conditions regarding interest rates.
Index and Margin
The index and margin are used to determine the interest rate and adjustments for an ARM. The index refers to a measure of certain interest rates, while the margin is a lender-added percentage to the index to form the new rate. According to the Federal Reserve Board, lenders base the index on a variety of indexes, which can include the Cost of Funds Index, constant-maturity Treasury securities and the London Interbank Offered Rate (LIBOR). The Federal Reserve notes that some lenders may even use their own index or formula, so it is important to ask and read to know what will be used in your case. Lenders use the margin to make up the rest of the interest rate. According to the Federal Reserve, this margin can vary across lenders, but usually margins are constant over the entire loan term. The Federal Reserve also notes that margins can be affected by your credit score, meaning the better your credit, the lower the margin added.
Rate caps are often written into ARM loans to set a cap or maximum amount that the interest rate can increase. According to the Federal Reserve, caps come in two forms, periodic adjustment caps and lifetime caps. Periodic adjustments place limits on the amount the rate can be adjusted each period, while lifetime caps limit the amount that the interest rate can increase over the entire term of the loan. According to the Federal Reserve Board, virtually all ARMs are required to have a lifetime cap.
What to Look For
The Federal Reserve Board notes that if the index moves up, your interest rate and in turn your payment will go up also in most cases. However, if the index falls, it doesn't always mean your payments and interest rate will fall as well. According to the Federal Reserve, not all ARMs adjust downward, so it is important to study the loan information and ask questions. The Federal Reserve says that instead of looking at the initial rate and monthly payment, you should instead look at the annual percentage rate or APR. The Federal Reserve says if the APR is much higher than the initial rate then you can expect your rate and payments to be much higher as well after the loan adjusts.