ARM Margin: What it Means, How it Works, FAQs

What Is ARM Margin?

The ARM margin is a fixed percentage rate that is added to an indexed (variable) rate to determine the fully indexed interest rate of an adjustable-rate mortgage (ARM). ARMs are one of the most common variable-rate credit products offered in the primary lending market.

Understanding ARM Margin

An ARM margin is a very important and often-overlooked part of the ARM loan’s interest rate. The ARM margin typically encompasses the majority of interest that a borrower pays on their loan. It is added to the product’s specified index rate to determine the fully indexed interest rate that the borrower pays on the loan. Terms for the indexed rate and ARM margin are detailed in the loan’s credit agreement.

ARM loans are a popular home mortgage product. They are structured with an amortization schedule that provides the lender with steady cash flow through installment payments. When rates are rising, the adjustable rate on an ARM increases, which benefits the lender and generates a greater level of interest income. ARM loans are beneficial for borrowers when rates are falling.

With a hybrid ARM, the borrower pays both fixed- and variable-rate interest over the life of the loan. The first few years of the loan require a fixed interest rate, while the remaining years have a variable rate. Borrowers can identify the fixed and variable years by the product’s quote. For example, a 5/1 ARM would have a fixed rate for five years, followed by a variable rate that resets every year.

Indexed Rates

The indexed rate on an ARM is what causes the fully indexed rate to fluctuate for the borrower. In variable-rate products, such as an ARM, the lender chooses a specific benchmark to index the base interest rate. A variable-rate product’s indexed rate will be disclosed in the credit agreement. Any changes to the indexed rate will cause a change in the borrower’s fully indexed interest rate.

ARM Margin Levels

The ARM margin is the second component involved in a borrower’s fully indexed rate on an ARM. In an ARM, the underwriter determines an ARM margin level that is added to the indexed rate to create the fully indexed interest rate that the borrower is expected to pay.

High-credit-quality borrowers can expect to have a lower ARM margin, which results in a lower interest rate overall on the loan. Lower-credit-quality borrowers will have a higher ARM margin, which requires them to pay higher rates of interest on their loan. That’s because borrowers with lower credit scores present a larger risk to the lender.

What Is a Typical Margin on an Adjustable-Rate Loan?

The ARM margin can vary from loan to loan and lender to lender. For example, the margin for a 5/1 ARM was 2.75% as of Oct. 28, 2021. Over the last decade, the margin rate for 5/1 ARMs has remained fairly consistent, hovering from 2.74% to 2.76%.

Margin rates may be higher or lower, depending on how an ARM is structured. For example, you may have an adjustable-rate loan with a margin below 2% or one that has a margin level above 3%. The lower the margin, the better it may be for borrowers, as margin affects fully indexed rate calculations.

The fully indexed rate is the sum of the index rate and the margin rate. This is the rate that you’ll pay for an ARM once the introductory fixed-rate period ends. So a lower margin could help to keep your fully indexed rate lower as well, potentially saving you money.

Indexed Rates vs. Margin Levels

Indexed rates and margin levels represent two different elements of an ARM’s cost. Again, the index rate is the benchmark rate that your lenders use as a guide for determining the interest rate on the loan. The margin represents the spread on the indexed rate.

When shopping for an adjustable-rate loan, it’s important to consider both the index rate and the margin carefully. For example, you may be offered a 5/1 ARM with a 1% index rate and a 4% margin. This would equal a fully indexed rate of 5%. Or you may be offered a 5/1 ARM with a 3% index rate and a 3% margin.

The margin level for the second loan is lower, meaning that your loan’s fully indexed rate has less room to increase over the life of the loan. But the indexed rate itself is higher to start, so your fully indexed rate is also higher, at 6%.