Let’s say you’re shopping for a mortgage, and you’ve decided you want an ARM.  You’re fairly certain you’ll only need this loan for 5-7 years (maybe you’re going to relocate or you’re buying a starter home and you’re confident you’ll be moving to a bigger place within that time frame).

You get rates for a 5/1 ARM from a couple of lenders. “5/1″ means the rate and payment stay the same for 5 years (and the loan is amortized over 30 years). After the 5th year, the loan adjusts every year.

You find two lenders with the same rate — 3.25%. Which one do you choose?

First, you need to know the answers to these 3 questions:

What is the index?

What is the margin?

What are the caps?

Why do you need to know this? Because if you still have this mortgage after 5 years when the loan starts to adjust, the index, margin and caps can make a big difference in what you pay every month. So if you want to save money on your mortgage, you need this information to find the cheapest deal.

Insider’s Tip: when choosing an ARM, compare not only the rate, but also the index, margin and caps

You email the loan officer at each lender and ask them for the index, margin and caps.

The first lender (let’s call them Bank ABC) comes back to you with “the index is the 1 Year LIBOR; the margin is 2.25%, and the caps are 2/2/5.”

The second lender (let’s call them Bank XYZ) says “it’s based off 1 Year LIBOR plus a margin of 2.25%. The caps are 5/2/5.”

What does this mean?

The index is what the lender looks at when the loan adjusts in Year 6. They’re both using the same index, 1 Year LIBOR.

The margin is what the lender adds to the index to determine your new interest rate. Again, the margin from both lenders is 2.25%. So far, the index and margin are exactly the same.

Now let’s look at the caps. Why did each lender give you three numbers (2/2/5 and 5/2/5)?

Because there are 3 caps. The first number refers to the initial cap (when the loan adjusts in Year 6). The second number refers to the annual cap (for every year thereafter), and the third number refers to the lifetime cap (how high the loan could go over the entire 30 year period).

Let’s look at an example:

You start out at 3.25%. You have that rate for 5 years. Now it’s Year 6. Bank ABC looks at 1 Year LIBOR (let’s say it’s at 4.20), adds the 2.25% margin, and determines that your new rate for Year 6 is 4.20 + 2.25% or 6.45% (which they would round up to 6.50%).

Here’s where the caps come into play. The index plus margin says your rate should be 6.50%. But the caps protect you. With the first ARM (with the 2/2/5 caps), your initial cap is 2%. That means that in Year 6, no matter where 1 Year LIBOR is, the worst case scenario is that your rate will be 2% over your starting interest rate (3.25%). Therefore, in this example, even though the index and margin says your rate should be 6.50%, the 2% cap limits the adjustment. Your new rate is your initial interest rate of 3.25% plus the 2% cap or 5.25%.

With the other loan from Bank XYZ, your rate would be higher – it would be 6.50% — because the index plus margin (6.50%) is within the allowed interest rate increase given by the cap (3.25% initial rate plus 5% initial adjustment cap).

Therefore, which loan saves you money?
The one from Bank ABC.

Insider’s Tip: when choosing between ARMs with the same rate, index, and margin, choose the one with the lowest initial cap

If you want to find out if an ARM would save you money, call Amerifund at (888) 650-7316 or fill out this form and someone will contact you.