Adjustable rate mortgage contracts are complicated legal documents that leave many people scratching their heads. As with a fixed rate loan, the annual percentage rate is the amount of interest that you pay over the course of a single year. However, adjustable rate loans have variable interest rates, which means that you need to pay as much attention to the loan margin as you do the APR.
Banks fund mortgages with borrowed funds. A bank can use money held in deposit accounts such as certificates of deposit to fund loans or it can borrow money from another bank. Unsurprisingly, banks charge interest on the money that they lend to one another. The Federal Open Market Committee sets a benchmark rate for interbank lending. Struggling banks and small institutions usually have to pay more to borrow money than larger institutions. However, the FOMC target rate has a direct impact on your APR at the time you take out a loan and it may also impact the APR you pay over the course of the loan term.
Banks make money by writing loans so it would not make sense for a bank to lend you money at the same rate of interest that the bank paid when it acquired those funds. The margin is the bank's mark up on the original loan. If a bank pays 2 percent to borrow money, it may charge 4 percent to lend that same money out to someone else. The poorer your credit, the higher the margin because banks mitigate risk by charging higher rates. Banks use margins to price both fixed rate loans and adjustable rate mortgages but you only need to know about the margin if you have an ARM.
When you take out an ARM loan, the bank must attach your interest rate to an index. Many banks use the United States prime rate which is an index that reflects the rate bank's charge creditworthy borrowers. The prime rate is indexed to the FOMC interbank rate. Other banks tie ARM rates to the yields being paid on federal treasury bonds. These indexes rise and fall over the course of time. Your loan margin remains the same. If the bank attaches your loan to the prime rate, then your interest rate moves up and down in conjunction with movements in the prime rate. If the index never changes then your APR remains the same for the entire loan term.
Caps and Floors
Banks typically add rate caps and floors to ARM agreements. The floor represents the minimum APR you can pay on the loan. The cap represents the highest APR you can pay over the course of the loan. The margin only remains meaningful if the underlying index remains with the realm of the cap and the floor. If the index falls low enough or rises above a certain point then you can forget about the margin for a while and get used to paying the floor or the cap rate. The margin becomes a factor again if the index shifts enough so that your rate is above the floor but below the cap.