The most typical feature of an adjustable-rate mortgage is its interest rate, which must be adjusted according to a change in the index that it is linked to. The rate on an ARM is, thus, variable or floating in nature, leading to periodical fluctuations in monthly payments.
Note that the initial or start rate may be lower than the fully indexed rate, and so it is often termed as the teaser rate. The floor (that refers to the lowest interest rate possible under an ARM contract), if it exists, will prevent the loan from ever adjusting lower than the start rate.
A hybrid ARM, which is the most common form of adjustable-rate mortgage today, has a fixed-rate period initially and the rate can begin to adjust only after this initial rate period is over. Depending upon the loan type, this period can range from 1 month to 10 years or more.
For example, a 7/1 ARM means your applicable interest rate will be fixed for the initial 7 years and then it begins to adjust according to the index and margin annually.
What is a fully indexed interest rate?
A fully indexed rate is a sum total of index and margin. While the index is variable in nature, the margin is fixed, but may vary from one lender to another. Suppose the index is 4% and the margin is fixed at 3%, the fully indexed rate would be 7% (4%+3%).
A fully indexed rate may not be reached in the first adjustment if there is an interest rate increase cap. For example, if the initial rate is 4% and the adjustment cap is 1% annually, then the adjusted rate after one year would be 5% only, which is obviously not the fully indexed rate.
What is adjustment interval?
The actual date when the interest on an ARM is changed is referred to as the adjustment date. The time period between the changes in the interest rate (or the monthly payment) is termed as adjustment interval.
The rate adjustment interval is typically displayed in a/b format, where “a” is the period until the first adjustment and “b” is the period between subsequent adjustments. Hence, a 3/1 ARM simply means that the rate will be adjusted for the first time after three years, and then it is adjusted every year.
Is the rate adjustment interval the same as the payment adjustment interval?
The rate adjustment interval and the payment adjustment interval are usually the same, typically in the case of a fully amortizing ARM. Because of the existence of different interest rate caps and payment caps, your payment needs to be adjusted to avoid negative amortization.