An Adjustable-Rate Mortgage (ARM) adjusts its interest rate periodically based on market conditions. The total interest rate you pay is the sum of two key components: an index rate and a margin. The index is a variable benchmark like the Secured Overnight Financing Rate (SOFR) or the Constant Maturity Treasury (CMT) rate; it moves with economic trends. The margin, however, is a fixed rate set by the lender at loan origination that remains constant throughout the life of your ARM. This margin compensates lenders for their risk and operating costs, effectively marking up the fluctuating index rate.
Your ARM interest rate equals the current index rate plus the fixed margin (Interest Rate = Index + Margin). For example, if the SOFR is 1.0% and your margin is 2.5%, your interest rate starts at 3.5%. When the index fluctuates, your interest rate adjusts accordingly, but the margin stays fixed—for instance, if SOFR rises to 3.0%, your rate becomes 5.5%. If SOFR drops to 0.5%, your rate adjusts down to 3.0%.
Understanding the margin is critical because it determines the baseline of your interest rate beyond the index. A lower margin means lower long-term costs, while a higher margin increases your interest and monthly payments. Since margins typically range between 2.0% and 3.0%, even small differences can significantly affect the total interest paid over the loan’s duration.
When comparing ARM offers from different lenders, focus on both the margin and the index to understand potential payment changes over time. Also consider rate caps and how the margin interacts with them to set the maximum possible interest rate you could pay. This knowledge will help you make informed decisions about an ARM and avoid common mistakes such as focusing only on teaser rates or ignoring the fixed margin component.
For more on Adjustable-Rate Mortgages and indexing, see our Adjustable-Rate Mortgage (ARM) glossary entry and learn about Variable Interest Rates.
Sources:
Consumer Financial Protection Bureau. Adjustable-Rate Mortgages. https://www.consumerfinance.gov/owning-a-home/mortgage-choices/adjustable-rate-mortgages/
Federal Reserve Bank of New York. SOFR and the Economy. https://www.newyorkfed.org/markets/reference-rates/sofr-and-the-economy
Investopedia. Adjustable-Rate Mortgage (ARM): Definition, How It Works, Example. https://www.investopedia.com/terms/a/arm.asp