What it means
An adjustable rate mortgage has two ingredients: an index that the lender does not control and a margin that was fixed when you signed. The index is published by an independent source, which stops lenders from simply raising your rate whenever it suits them.
Common indexes include the Secured Overnight Financing Rate, various Treasury yields and, historically, cost of funds measures published by regional banking bodies. Each behaves differently, with some responding quickly to central bank moves and others lagging by months because they average older data.
The choice of index has a real effect on how a borrower experiences the loan. A fast-moving index passes rate rises through almost immediately, while a slow-moving averaged index cushions the shock on the way up but is equally slow to deliver relief on the way down.
Loan documents specify a look-back date, meaning the index value used is the one published a set number of days before the adjustment. This is why your new rate can be based on market conditions from six weeks earlier rather than the day the letter arrives.
Rate caps sit on top of all this and limit how far the rate can move at each adjustment and across the life of the loan. A common structure limits the first adjustment to five percentage points, subsequent adjustments to two, and the total lifetime increase to five above the starting rate.
In practice
Real-world examples.
Example
A first-time buyer takes a five-year adjustable rate mortgage tied to a Treasury-based index at a starting rate of 5.25%. When the fixed period ends the index has risen by 1.80 percentage points, so his rate resets upward and his monthly payment increases by roughly $290.
Example
A commercial property investor refinancing a $4 million loan compares two lenders offering the same margin but different indexes. She chooses the slower-moving averaged index because her rental income adjusts annually and she wants her interest cost to lag rather than lead.
Example
A credit union rewrites its adjustable rate mortgage documents after an old index is discontinued, replacing it with a successor rate and a small spread adjustment so existing borrowers end up at approximately the same rate as before the switch.
Formula
Calculation
Fully indexed rate = current index value + margin, then capped by whatever periodic and lifetime limits the loan sets.
Take a borrower whose adjustable rate mortgage uses an index currently published at 4.25% and carries a margin of 2.75%. The fully indexed rate is 4.25% + 2.75% = 7.00%.
Her current rate is 5.50% and the loan has a periodic cap of 2.00 percentage points per adjustment. The proposed increase is 7.00% - 5.50% = 1.50 percentage points, which sits inside the cap, so the new rate is the full 7.00%.
On a remaining balance of $300,000, annual interest goes from $300,000 x 5.50% = $16,500 to $300,000 x 7.00% = $21,000. That is an extra $4,500 a year, or $4,500 / 12 = $375 more per month in interest alone, which is the number the household actually has to budget for.Case study
Seen in the real world.
Ridgeway Community Bank is a fictional lender used here as an illustrative example. It had for years written adjustable rate mortgages against a slow-moving averaged index, which made its loans popular with borrowers who disliked sudden payment jumps.
When market rates rose quickly, Ridgeway found that its own funding costs climbed within weeks while the index governing its mortgage book only caught up over the following year. The mismatch squeezed the margin on roughly $180 million of loans and forced an uncomfortable conversation with the board about interest rate risk.
In this illustrative scenario the bank did not abandon the product but changed how it was priced and hedged. New loans moved to a faster-responding index with a slightly lower margin, and the treasury team began matching the timing of its funding to the index reset schedule rather than treating the two as separate problems.
Watch out
Common mistakes.
- Comparing two adjustable rate mortgages on their starting rate alone. The index and margin determine what you pay after the introductory period, which is where most of the loan's life is spent.
- Assuming the lender picks the index value it likes. The index is published independently and the loan document names both the source and the look-back date.
- Forgetting that caps limit the size of a change but not the direction. A capped adjustment simply spreads a large market move across more than one reset date.
Questions
People also ask.
What is the difference between the index and the margin?
The index moves with the market and the margin is a fixed add-on set when you take the loan, and together they make your fully indexed rate.
Can my rate fall as well as rise?
Yes, if the index falls, though many loans set a floor below which the rate will not go.
How often does the index get applied to my loan?
Only at the adjustment dates written into your loan, most commonly every six or twelve months after any fixed introductory period ends.
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