How the Monthly Payment on an ARM Is Determined

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An ARM payment is a payment you have to make each month on your Adjustable Rate Mortgage (ARM). The monthly payment includes principal and interest. While the principal usually remains constant, the interest changes every month depending on market conditions. Because of this, your monthly ARM payments can seem unpredictable, going up and down for little discernible reason. By understanding the factors that determine your monthly payments, you can remove much of that uncertainty, allowing you to be better prepared as you plan how much money you spend each month.

Understanding ARM Payments

As mentioned above, your monthly payments are made up of two components--the principal and the interest. The principal is a portion of the money you borrowed when you took out your adjustable rate mortgage. Every time you pay the principal, the money you owe decreases. The interest rate is the profit the mortgage lender earns for issuing and maintaining the mortgage.

The ARM interest rate starts out as fixed interest rate, remaining the same for a certain period. This is known as the adjustment period. Depending on the type of ARM, the adjustment period can last anywhere between 1 and 10 years.  Once the adjustment period ends, the interest rate starts to change on a monthly basis.

Margin and Index

At this point, the interest rate is set based on two factors: the margin and the index. The margin is a fixed number that the lender decided on at the beginning of the loan. As such, it remains the same for the entire life of the loan. The index is a variable number that is based on the average interest rate at which certain financial institutions borrow unsecured funds.

There are a number of indexes lenders can choose from. They include the 11th District Cost of Funds Index (COFI), the 12-month Treasury Average Index (MTA), the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT) and the National Average Contract Mortgage Rate. You can find out which index the lender is using simply by asking or by looking up your ARM details on the lender's website. The indexes are posted online, though there may be some delay between when the indexes are implemented and when the numbers are available to the public. In other cases, those numbers are updated so frequently that you'll have to check every day to see which ones will wind up being used to determine your interest rate for each particular month.

Index Caps and Amortization

Index caps are the maximum limits on how much the interest rates can rise. They can be divided into two types: periodic caps and lifetime caps. Lifetime caps limit how much the interest rates can change during the entire life of the loan, while periodic caps limit how much the interest rates can change during a specific period. That period can be anywhere from a month to a year.

The index caps are ostensibly designed to make sure your monthly payments don't get too high. However, what many borrowers don't realize is that if the monthly payments rise above the caps, the extra money gets transferred towards the balance. This is known as negative amortization. While it doesn't affect the principal, it ensures that you will have to pay the loan over a longer period than what you originally agreed to. You can avoid this by getting a fully amortizing AMR. This ARM has a longer adjustment period and higher monthly payments. Both of those things are meant to collect enough money to offset negative amortization once it becomes an issue.