When you take out a loan with a variable rate, the rate is typically set using some outside indicator of prevailing interest rates. It's usually set to be a bit higher than that published rate. The difference is known as the loan margin by definition, and it can be found in your loan agreement. The loan margin is something you should understand when you agree to an adjustable rate mortgage, credit card or other variable rate loan.
TL;DR (Too Long; Didn't Read)
Mortgage loan margin refers to the difference in interest rates between the loan and the benchmark interest rate used to set it. Make sure you understand the margin on a loan you take out.
Understanding Adjustable Rate Mortgages
When you borrow money through a mortgage loan to buy property, the amount you borrow initially is known as the principal. This isn't all that you must pay back. You also have to pay back interest, which enables the bank or other lender to make a profit.
Some mortgages are fixed rate mortgages, meaning that the rate remains the same throughout the life of the loan. Others are adjustable rate mortgages, meaning that the rate can fluctuate over the life of the loan based on prevailing interest rates. Exactly when the rate can change and how much it can go up or down depends on your loan agreement.
Adjustable Vs Fixed Rate Loans
Adjustable rate mortgages can be more risky since rising interest rates can also raise your monthly payment. If you don't have a good gap between your income and the amount you were initially paying, you may have difficulty paying for your home. To make up for that risk, adjustable rate loans typically start out charging less interest than fixed rate loans available at the same time. On the other hand, if interest rates drop after you take out an ARM, you can actually save money compared to a fixed rate loan.
Understanding Mortgage Loan Margin Meaning
Adjustable mortgage rates aren't picked out of thin air, and they're not just dependent on a banker's overall assessment of interest rates. Instead, they're set based on a public, or benchmark, interest rate that's usually computed by an industry group based on data about lending rates. That rate, also known as an index rate, is publicly available and published in newspapers and on financial news and information sites.
Mortgage lenders typically don't use the rate published as the rate for adjustable mortgages, however. They usually add a little bit to it in order to make profit above lending at the published index rate. The difference between the published rate and the actual rate a borrower pays is known as the loan margin. It's generally spelled out in your loan agreement, along with the benchmark rate that's used.
Not all margins are the same. Borrowers with a better credit rating can often secure lower-margin loans. You can also shop around for a lender who will offer a lower margin in the terms of your ARM. This doesn't just apply to mortgage; personal loans, business loans and credit cards may also state the interest in terms of a published benchmark rate and a margin.
LIBOR and Different Lending Benchmarks
Different mortgages and other loans may use different benchmarks. One of the most common benchmark rates historically has been the London Interbank Offered Rate, which is a measure of the rates banks charge to each other to borrow money in the short term. The rate is called LIBOR, and margin based on it is known as LIBOR margin.
LIBOR, however, is being eliminated due to a scandal over how it was computed. Lenders are now looking for other benchmark rates to use to set their loan interest rates.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.