Adjustable rate mortgages have an interest rate that is based on two factors. First, the rate is based on an index. Index rates are interest rates that are available in the broad market and are subject to change. Some well known index rates include the London Interbank Offered Rate, the 11th District Cost of Funds, and the 12-month moving Treasury average. Those three indexes are usually referred to, respectively, as LIBOR, COFI, and 12MAT or 12MTA. To an index rate, the bank adds an additional margin, sometimes also called a spread. Your loan's ability to adjust may be limited by other terms in the loan documents.
Review your loan document, usually referred to as a promissory note, to see what the spread and index rate are. The document will also usually tell you which variant of the index rate is used and where to find it -- the six-month LIBOR or the "Wall Street Journal Prime Rate," for example. Look carefully for any description of any ceilings, floors or adjustment caps that may limit how much your loan's rate can move.
Look up the index rate in your loan's recommended place, if it has one. If your loan doesn't specify a particular place to find a rate, you can usually find it on a financial website. For instance, if you loan is tied to the six-month LIBOR, you might look it up and find the rate to be 0.38 percent on a given date.
Add the index rate to your loan's spread to find what could be your fully-indexed rate. For example, if your index is 0.38 percent and your spread is 325 basis points, which is equal to adding 3.25 percent, your fully-indexed rate might be 3.63 percent -- but you're not done yet.
Subtract your new loan rate from your previous loan rate to find the difference. For instance, if your loan was 5.25 percent and it goes down to 3.63 percent, the difference would be 162 basis points, or 1.62 percent. Compare that to your yearly adjustment cap and choose the smaller adjustment. If your loan can only go down or up 100 basis points per year, then it would only go down to 4.25 percent, instead of going all of the way down to 3.63 percent. While this provision can hurt you when rates go down, it helps you when rates go up.
Compare the rate you calculated after applying your adjustment cap to your loan's floor rate, which is the lifetime lowest rate that the loan can go to, and choose the highest one. For instance, if your loan's floor is 3.75 percent but your fully indexed rate is 3.63 percent, your loan rate will actually be 3.75 percent.
Do the same with your loan's ceiling or lifetime maximum rate, which is the highest rate that it can hit. If your loan adjusts to 9.97 percent, but its lifetime max is 9.75 percent, your rate would be 9.75 percent. If the fully-indexed rate that you calculate is less than the maximum, though, then the lower rate.
If you don't have the rate for the date that your loan is set to adjust, anything you calculate will be an estimate.
- Bankrate: LIBOR, Other Interest Rate Indexes
- The Mortgage Professor: How Do Adjustable Rate Mortgages Work?
- Bankrate: Check Caps, Floors Before Refinance
- Corporate Finance Institute. "Floating Interest Rate: What Is a Floating Interest Rate?" Accessed Aug. 17, 2020.
- Corporate Finance Institute. "Floating Interest Rate: Use of Floating Interest Rate." Accessed Aug. 17, 2020.
- Corporate Finance Institute. "Floating Interest Rate: Uses of Floating Interest Rate." Accessed Aug. 17, 2020.
- Debt.org. "How is Credit Card Interest Calculated?: Variable Interest Rates." Accessed Aug. 17, 2020.
- Freddie Mac. "How it Works: Adjustable Rate Mortgages (ARMs)." Accessed Aug. 17, 2020.
- U.S. Securities and Exchange Commission. "Floating-rate Bond (or Variable or Adjustable rate Bond)." Accessed Aug. 17, 2020.
- Corporate Finance Institute. "Interest Rate Swap." Accessed Aug. 17, 2020.
- If you don't have the rate for the date that your loan is set to adjust, anything you calculate will be an estimate.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.