Mortgage Concepts is a recurring video series covering best practices and compliance education for California mortgage loan originators (MLOs). This video explains how the interest rate on an adjustable rate mortgage (ARM) is calculated for each adjustment.
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ARM features
Adjustable rate mortgages (ARMs) are adjusted periodically to change the interest rate and monthly payment amount. The amount of change in the rate is based on movement in figures in an index identified in the ARM note, which figure is added to a lender’s margin, and limited by a rate cap.
The index is a benchmark, presenting periodic interest rate figures. Rate figures published in the index reflect changes in financial market interest rates.
The margin is a percentage figure, say, 3.5%, set by the ARM lender and stated in a provision in the ARM note.
The cap rates are stated in the ARM note. On an interest rate adjustment, they limit the rise of the interest rate or payment amount. Several varieties exist, typically including:
- an initial interest rate cap limiting the first interest rate adjustment;
- a periodic interest rate cap limiting subsequent interest rate adjustments;
- a lifetime interest rate cap further limiting any interest rate adjustment; and
- periodic payment caps.
The cap rates are in contrast to “floor rates” which set the lower end amount of the note’s interest rate and the lowest adjustment for payments.
ARMs have rate periods. When a period expires, an adjustment in the ARM interest rate is triggered for setting the interest rate charged during the following rate period. The adjusted ARM rate charged during the following period is calculated as the total of:
- the current index figure; and
- the margin figure;
- which together establish a fully-indexed ARM interest rate;
- limited by the rate cap figure for the period.
Interest rate caps in the half-cycle of rising rates
All rate cap figures reference and apply only to the ARM rate for the introductory rate period. Together, the two rates set the ceiling for adjustments to the ARM rate to be charged.
The initial interest rate cap applies to the first rate adjustment to limit the amount the ARM interest rate can rise above the introductory interest rate.
The periodic interest rate cap applies to each rate adjustment after the first interest rate adjustment to limit the amount the ARM interest rate can increase over the interest rate charged during the prior period.
A lifetime interest rate cap sets the maximum increase in the ARM interest rate for any ARM rate adjustment exceeding the ARM’s introductory interest rate.
The interest rate adjustment regulations do not set the caps nor present guidelines for setting them. [12 USC §3806(a); 12 CFR 225.145]
The lifetime interest rate cap required on all consumer-purpose ARMs secured by a lien on a one-to-four unit residential dwelling is Congress’s response to what became seemingly never-ending interest rate increases on ARMs in past decades – thus defying the derogatory “topless ARM” epithet from the ‘80s.
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Applying the variations in rate cap figures
Rate cap ceilings for ARMS are commonly expressed in a series, for example, as 5/2/5 or 2/2/6. The numbers disclose the maximum percentage rate increase for setting periodic adjustments in the interest rate charged on the ARM:
- the first number refers to the maximum increase in the ARM rate on the first adjustment above the introductory ARM rate.
- the second number is the maximum increase in the ARM rate on subsequent adjustments above the rate charged during the prior period, and
- the third number is the maximum increase on any adjustment in the ARM rate charged above the introductory ARM rate.
For instance, for the 2/2/5 rate cap arrangement:
- the rate increase on the first adjustment cannot exceed 2% over the ARM introductory rate;
- each further periodic rate increase cannot exceed 2% over the rate for the prior period; and
- the lifetime rate increase sets the maximum rate on any adjustment at 5% over the introductory ARM rate.
ARM disclosure worksheet
A buyer, owner or their transaction agent (TA) uses the ARM Disclosure Worksheet published by RPI when locating the most advantageous ARM financing available for funding the purchase or refinance of a property. The form allows the agent to provide the buyer or owner with a checklist for conducting an interview with mortgage lenders and noting for comparison the terms they offer on an ARM. [See RPI Form 320-1]
The contents of the ARM Disclosure Worksheet include:
- the name of the loan plan, lender, loan officer and the property’s address [See RPI Form 320-1];
- the monthly interest rate adjustment, when the first adjustment occurs and the note ceiling rate, as well as the initial interest rate and how long it is in effect [See RPI Form 320-1 §§1 through 4];
- whether full amortization, interest only payments or buildup of the principal amount borrowed is a feature of the loan, and the terms [See RPI Form 320-1 §§5 through 7];
- whether a due-on-sale clause exists in the trust deed, and the conditions for consent to an assumption on a resale [See RPI Form 320-1 §8];
- whether a prepayment penalty exists and, when applicable, for what period it applies and the terms [See RPI Form 320-1 §9]; and
- whether the mortgage provides for convertibility to a fixed rate loan at the borrower’s election, and under what conditions. [See RPI Form 320-1 §10]
Scenario 1
Let’s say your homebuyer started with a 4.5% introductory or “teaser” rate on a $500,000 ARM. The lender’s margin figure is 3.5%, and the index used is the Federal Cost of Funds Index (COFI). Both are stated in the ARM note. Added together, the two figures result in what is called a fully-indexed ARM rate.
The ARM adjusts annually, limited by a 2/2/5 cap structure. At the first adjustment, the COFI figure is 2.0%. By the second adjustment, the index figure has risen to 4.5%.
The following example for the adjustment in payments displays only the principal and interest (PI) portion of the total monthly payment of PITI due the mortgage servicer. The payment examples do not include TI installments due for the escrowing of property taxes, insurance, homeowners’ association fees and other similar impounds.
What is the interest rate computed for the ARM on the first adjustment?
- The new rate is 5.5%. It is the fully-indexed rate and represents the index figure of 2.0% plus the margin figure of 3.5%. The fully-indexed rate is not higher than the limit at the combined introductory rate and the cap rate.
What is the interest rate on the ARM as calculated for the second adjustment?
The new ARM rate is limited to 7.5%, calculated as follows:
- By the second adjustment, the index rate increased to 4.5%, a rate seen during periods of high rates of consumer inflation. When the 4.5% index rate is added to the 3.5% margin figure, the result is the fully-indexed rate of 8.0%.
- However, due to the 2% rate cap for the second adjustment the new ARM rate may not increase more than two percentage points above the rate of 5.5% charged in the prior period. Thus, the adjustment is at a 7.5% ARM rate.
The breakdown of the ARM rate and payment amount looks like this:
| ARM Interest Rate | Monthly Payment (Rounded) |
| Teaser rate: 4.5% 1st adjustment to 5.5% | $2,530 $ 2,840 |
| 2nd adjustment to 7.5% | $ 3,500 |
Additionally, some ARMs with interest rate caps have a carryover feature. The carryover feature is contained in the ARM note. It allows the lender to “carryover” the portion of the interest rate increase which exceed the periodic interest rate caps, applying the excess amount to spillover into the next rate adjustment.
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Scenario 2
Consider a homebuyer with a 6.5% fully-indexed introductory interest rate on a $500,000 ARM. The ARM adjusts annually and has a carryover provision. No cap rate exists on the first adjustment to limit the ARM rate increase. However, the ARM has a 2% periodic interest rate cap and a 5% lifetime interest rate cap.
On the first adjustment, the index figure is up 3%. In the second year, the index figure is 2%, down 1%.
What is the interest rate on the ARM for the second adjustment?
The interest rate for the second adjustment is 8.5%.
The example does not include the payment for impounds of taxes, insurance, homeowners’ association fees or similar impounded items escrowed with the lender.
The breakdown goes like this:
| ARM Interest Rate | Monthly Payment (Rounded) |
| 1st year @ 6.5% | $ 3,160 |
| 2nd year @ 8.5% | $ 3,840 |
| 3rd year @ 8.5% | $ 3,840 |
The index figure for calculating the ARM rate for the first adjustment increased 3%. However, the interest rate increase permitted on the first adjustment is limited by the 2% interest rate cap. The remaining 1% index figure increase is “capped out” and carried over to be applied to calculations for the next adjustment.
For the second adjustment, the index figure drops 1%. Here, the drop is offset by the 1% carryover from the previous adjustment due to its rate cap limitation. The result is the ARM interest rate remains at 8.5%.
Note: This example used the fully-indexed introductory interest rate as the base for adjustments. However, most ARM introductory rates are discounted or teaser interest rates, not the fully-indexed rate. When the introductory rate is at the fully-indexed rate, the first adjustment reflects a rate equal to the index figure plus the margin figure set in the ARM note, subject to applicable caps.
When an ARM has an introductory interest rate less than the fully-indexed note rate, and a 5/2/5 structure, the interest rate can increase on the first adjustment by up to 5% over the teaser rate — a payment shock for any homebuyer who lives by a budget. Here, a mortgage originator faced with a homebuyer determined to borrow on an ARM may search for similar mortgage products with a lower initial interest rate cap – say a 2/2/6 structure, which allows for more gradual interest rate and payment increases.
However, the critical math for the interest paid on an ARM is the total of the lender’s margin figure and the index figure, reduced by the limitation on adjustments by the cap rate.
Payment caps
Another type of cap also available on an ARM which is not a “qualified mortgage,” is known as a payment cap. The payment cap sets the total amount of PI payments due on the ARM for each adjustment. When the homebuyer has an ARM payment of $3,000 for PI, and the ARM has a payment cap of 10%, the maximum increase in the PI portion of the ARM payment on an adjustment is $300, for a total payment of $3,300 on the first adjustment – regardless of the extent of the interest rate adjustment.
However, with payment caps the amount of accrued interest unpaid due to a payment cap is not eliminated and needs to be paid at some point. The unpaid interest accrued is added to the ARM principal balance, a condition called negative amortization. This interest added to principal produces a compounding of interest as interest now accrues on the deferred interest.
Editor’s note — ARMs with the potential for negative amortization are only allowed under general ability-to-repay requirements. Negative amortization is not permitted for qualified mortgages. [12 CFR §1026.43(c)(5)(ii)]
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