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The interest of adjustable-rate mortgages (ARM) are tied to the index and margin. The index is a reference point for the interest rate and will vary based on the market. The margin, on the other hand, is a firm set of percentage points that the lender determines. When added together, a new interest rate for the loan is established. Ultimately, this will affect how much borrowers will pay every month for the loan.
Adjustable rate mortgages (ARMs) have become an increasingly popular option for homebuyers in recent years. Unlike fixed rate mortgages, ARMs offer lower initial interest rates that can make monthly payments more affordable, at least at first. But ARMs come with some complexity that fixed rate loans do not. One of the key factors to understand is the margin – what it is, how it works, and how it impacts your loan. In this article, we’ll demystify the margin on ARMs so you can make an informed decision when shopping for a home loan.
What is the Margin on an ARM?
The margin is one of two main components that make up the interest rate on an adjustable rate mortgage. The other component is the index – an interest rate benchmark that changes over time. Common indexes used for ARMs include the Secured Overnight Financing Rate (SOFR), the London Interbank Offered Rate (LIBOR), and the 11th District Cost of Funds (COFI).
Your lender sets the margin when you take out the ARM loan. Unlike the index which fluctuates, the margin stays constant for the life of your loan. To calculate your ARM’s interest rate, the lender adds the margin to the current index value.
For example:
- Index value: 2%
- Margin: 2.5%
- Index + Margin = Interest Rate
- 2% + 2.5% = 4.5%
So if the current index value is 2% and your margin is 25%, your interest rate would be 45%.
The margin may range anywhere from around 1.5% to 3% for a well-qualified borrower. The exact margin depends on factors like your credit score down payment and general market conditions. The higher your credit score and down payment percentage, the lower margin you can likely qualify for.
How the Margin Impacts Your Interest Rate
As the index fluctuates over time, your interest rate will change accordingly. But the margin stays constant. Here’s an example of how the index and margin combine to determine your interest rate:
Year 1
- Index value: 2%
- Margin: 2.5%
- 2% + 2.5% = 4.5% interest rate
Year 2
- Index value rises to 2.25%
- Margin stays at 2.5%
- 2.25% + 2.5% = 4.75% interest rate
Year 3
- Index value decreases to 1.75%
- Margin remains 2.5%
- 1.75% + 2.5% = 4.25% interest rate
So when the index goes up, your rate goes up. And when the index decreases, your rate goes down accordingly. The margin acts as a constant buffer that’s added to the changing index.
Why the Margin Matters
Understanding how the margin impacts your interest rate is key for a few reasons:
1. The lower the margin, the better
Since the margin adds a constant percentage to your rate, you want it to be as low as possible. All else being equal, a lower margin will result in a lower interest rate.
2. Shop and compare margins between lenders
The margin varies by lender. Comparison shop to find the lender offering the lowest margin for your situation. A 0.25% difference in margin can make a noticeable impact on your monthly payment.
3. You may be able to negotiate the margin
Many borrowers don’t realize the margin is negotiable just like the interest rate. Come prepared with rate quotes from other lenders and ask your lender to match the best margin you’ve been offered. This negotiation can potentially save you thousands of dollars over the loan term.
4. Pay attention to the margin when comparing ARM loans
It’s easy to get caught up in the teaser rate or starting interest rate when reviewing ARM loans. But take note of the margin too. A lower teaser rate may come with a higher margin, which could mean higher long term rates.
What Impacts Your Margin?
As mentioned earlier, the main factors that influence your margin are:
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Credit score and history – Borrowers with higher credit scores and clean histories generally get lower margins
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Down payment percentage – The more you’re able to put down, the better margin you can expect. At least 20% down is ideal.
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Loan program – Government-backed loans like FHA and VA may have different margin requirements than conventional loans
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Overall market conditions – When rates are low and competition is high, you may see lower margins from lenders
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Lender practices – Each lender sets their own typical margins. Comparison shop for the best deals.
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Negotiation – Be ready to negotiate with your lender for the lowest margin they can offer
The best way to maximize your chances for a lower margin is to boost your credit score, save for a larger down payment, and shop multiple lenders.
Common Margin-Related ARM Terms
There are a few other key terms related to margins and ARM loans:
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Fully indexed rate – Your margin + the index at the time you apply. Indicates the highest possible rate at first adjustment.
-
Interest rate cap – Limits how much your rate can increase at each adjustment. Often caps increases at 1% per adjustment or 5% over the life of the loan.
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Lifetime rate cap – The maximum rate your loan could potentially reach if the index increased substantially. Provides a safety net for worst-case scenarios.
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Rate floor – The lowest possible rate your ARM could adjust down to, often around 2-3%. Protects the lender from rates dropping too far.
Having a solid grasp of these terms is helpful for understanding the full picture of how an adjustable rate mortgage works.
The Takeaway on Margins for ARMs
While it may sound complex at first, the margin on an adjustable rate mortgage is quite straightforward once you understand the basics. The margin acts as a constant component that’s added to the fluctuating index to determine your interest rate.
Aim for the lowest margin possible by boosting your credit, saving for a larger down payment, comparing lenders, and negotiating. Keeping an eye on the margin when shopping for an ARM is just as important as the starting interest rate. Equipped with knowledge of how margins function, you can feel confident in your ability to make the best financing decision for your home purchase or refinance.
What is an adjustable-rate mortgage?
An ARM is a loan with a fluctuating interest rate, which depends on the index and margin. This is also known as a variable-rate mortgage or floating mortgage. ARMs can change as often as one year, three years, and even five years. However, this change takes place only after the initial period is over.
This is the opposite of a fixed-rate mortgage, where the interest remains the same for the duration of the loan. ARMs also typically have lower monthly payments compared to fixed-rate mortgages. However, the difference may not be much. Other things to keep in mind about ARMs are:
- Your payments can vary month-to-month
- You may end up owing more money than you originally borrowed.
- You could face a penalty if you pay your ARM ahead of time.
Refer to the Consumerfinance.gov ARMs handbook for a detailed look at ARMs and all they entail.
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How much the interest rate changes on an ARM depends on the index, which is based on the current market conditions. If the index rate rises, so will the interest rate and monthly payment. If it falls, however, both the interest rate and monthly payment could also drop. Lenders will base the interest rates of an ARM on a few indexes, including the Cost of Funds Index (COFI) and 1-year constant-maturity Treasury (CMT) securities. Other lenders will use their own cost of funds as an index, allowing them to have more control.
If you’re thinking about an ARM, consider asking the lender what index they’ll be using, how often it’s changed in the past, and where it’s published.
The margin is the percentage points you’ll add to the index to set the interest rate. The amount of the margin ultimately depends on the lender and the type of loan, but you can negotiate to keep it low. It also won’t change after you’ve closed the loan.
What Is a Mortgage Margin?
FAQ
What is the margin in an adjustable rate mortgage also known as?
What is the margin in an adjustable rate mortgage Quizlet?
What is a loan rate margin?
What is the maximum DTI for ARM?
What is a margin on an adjustable-rate loan?
The margin represents the spread on the indexed rate. When shopping for an adjustable-rate loan, it’s important to consider both the index rate and the margin carefully. For example, you may be offered a 5/1 ARM with a 1% index rate and a 4% margin. This would equal a fully indexed rate of 5%.
What is an adjustable rate mortgage?
An **adjustable-rate mortgage (ARM)**, also known as a **variable-rate mortgage**, is a type of home loan with an interest rate that can fluctuate periodically based on market conditions.
How do I Choose an adjustable-rate loan?
When shopping for an adjustable-rate loan, it’s important to consider both the index rate and the margin carefully. For example, you may be offered a 5/1 ARM with a 1% index rate and a 4% margin. This would equal a fully indexed rate of 5%. Or you may be offered a 5/1 ARM with a 3% index rate and a 3% margin.
What are margins & indexes in an adjustable rate mortgage?
Margins and indexes are two of many terms that determine your monthly payment for an adjustable-rate mortgage. It’s also important to understand caps, carryover, and other terms. If you’re considering an adjustable rate mortgage, read the Consumer Handbook on Adjustable Rate Mortgages (CHARM) booklet .