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Fully Indexed ARMs Explained

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ARM is the three-letter acronym that stands for Adjustable Rate Mortgage. There are of course two primary mortgage types, a fixed rate mortgage where the rate never changes throughout the life of the loan and an adjustable-rate mortgage where the rate can and most usually does adjust at some point in the life of the loan. To understand what a fully indexed ARM we need to understand how they work, how they can adjust and when.

An ARM has an index, a margin and caps.  The index is the benchmark number based upon a universally accepted base. The index might be based upon the current price of a carton of vanilla ice cream. Whatever the prevailing price of a gallon of vanilla is for that adjustment point.

If the price of a gallon of vanilla ice cream is $5.00, that’s where the adjustment begins. That’s why the index for a mortgage ARM can change because the price of ice cream is likely to change up or down over time.

The margin is the predetermined number that is added to the index to help calculate the new mortgage rate for the loan term until the time for the next adjustment. If the margin for example were 2.00, then 2.00 would be added to the price of a gallon of ice cream, or in this example 7.00% would be the new rate.

Caps? Caps are a form of consumer protection as it relates to a loan program. A cap might be 1.00% or 2.00%. This means that whenever it comes time for the next adjustment, no matter what the index and margin add up to be, the new rate cannot go beyond the cap. If the rate were say 6.00% and it’s coming up time for an adjustment, the adjustment is limited by whatever cap is present in the mortgage note.

For example, let’s say the cows go on strike and suddenly the price of milk goes through the roof. What if the price for a gallon of ice cream hit $10.00 per gallon? Again, using this example, the new rate would jump from 6.00% to 12.00%. Such a payment shock could very well put the borrowers into financial peril.  There can be an initial cap and a lifetime cap.

The initial cap is how high or low the new rate can be at the first adjustment; there’s a cap on any subsequent adjustment and a cap on how much the rate can ever change.  These parameters can never change. Doing so would be to go against what is hard-wired into the mortgage program.

The fully indexed ARM is the combination of the index plus the margin. Easy-peasy.


Written by David Reed for Copyright © 2023 Realty Times All Rights Reserved. Reed is from Austin, Texas and is the author of The Real Estate Investor’s Guide to Financing, Your Guide to VA Loans and Decoding the New Mortgage Market. A Senior Loan Officer and Mortgage Executive for more than 20 years, he has also appeared on CNN, CNBC, Fox Business, Fox and Friends and the Today In New York show.