Adjustable-rate mortgages (ARMs) come with built-in rules called embedded features that determine how your interest rate changes over time. These features are fundamental to the loan’s structure and directly impact your monthly payments and financial planning.
The primary embedded ARM features include:
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Index: This is a publicly available benchmark interest rate your loan follows. Common indices include the Secured Overnight Financing Rate (SOFR). The index fluctuates with the market, causing your interest rate to move accordingly. For more details on how the index works, see our article on Rate Index.
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Margin: A fixed percentage set by the lender that is added to the index to determine your interest rate. It remains constant throughout the life of the loan. Learn more about margins in our Margin (ARM Loan) page.
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Interest Rate Caps: These set limits on how much your interest rate can increase at various points during the loan term, protecting you from sudden large payment increases. Caps typically include an initial adjustment cap, subsequent adjustment caps, and a lifetime cap. A detailed explanation can be found in our Variable-Rate Loan Cap page and Lifetime Adjustment Cap article.
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Conversion Option (if available): Some ARMs include an option to convert to a fixed-rate mortgage at a later date, providing flexibility in managing interest rate risk. See Convertible ARM for a deeper dive into this feature.
How Embedded Features Work Together
Suppose you have a 5/1 ARM with an initial rate of 5.0%, an index tied to SOFR at 4.0%, a margin of 2.5%, and caps of 2/2/5. Here’s how your rate adjusts after five years:
- Calculate the fully indexed rate: 4.0% (index) + 2.5% (margin) = 6.5%
- Apply the initial adjustment cap: Your rate cannot rise more than 2% above the 5.0% initial rate, so the maximum new rate is 7.0%
- Since 6.5% is below the cap, your new rate is 6.5%
If the index had jumped to 6.0%, the fully indexed rate would be 8.5%, but the cap keeps it at 7.0%, preventing higher payments.
Summary Table of Embedded ARM Features
| Feature | Description | Changes Over Time |
|---|---|---|
| Index | Public benchmark rate (e.g., SOFR) your interest rate follows. | Yes, fluctuates with the market. |
| Margin | Fixed lender-added percentage. | No, fixed for the loan’s duration. |
| Caps | Limits on interest rate increases to protect borrowers. | No, set at loan origination. |
Understanding these embedded features is essential for anyone considering an ARM, letting you make informed decisions about mortgage risks and costs.
For official guidance, review Consumer Finance’s Adjustable-Rate Mortgage overview and the Federal Reserve’s explanation of ARM.