Calculating APR on ARMs

When calculating APRs on adjustable rate products, you must look at your initial interest rates to determine your course of action. If your initial interest rate is equal to the index interest rate plus your margin (taking into account any rounding), your adjustable rate loan is "fully indexed."With these types of loans, you calculate the APR the same way you would with a fixed-rate loan. That is, one payment stream (two if you disclose a final payment) at the fully indexed rate.

If the adjustable rate product has an initial interest rate that is lower (discounted) or higher (premium) than the fully indexed rate then you must produce a blended rate APR as stated in the Official Staff Commentary to Regulation Z, Section 226.17 (c) (10). Under this type of calculation, you must calculate the payment streams beginning with the initial rate and subsequent rate(s) increasing (or decreasing in the case of a premium rate) the interest rate as quickly as is allowed by the contract until you reach the fully indexed rate, ceiling (or floor) rate or the lifetime rate cap (maximum lifetime rate change). Once you have the payment streams calculated, you then calculate the APR based on the multiple payment streams.

For example, if your fully indexed rate is 7.25% but you are offering a "teaser" rate of 4.5% for one year. And, your initial rate can change 1% at the first change and subsequent rate changes can be 2% every twelve payments. Your payment streams would be as follows:
X payment amount at 4.5% for 12 payments.
Y payment amount at 5.5% for 12 payments.
Z payment amount at 7.25% for the remaining number of payments.

The APR would be calculated on these three payment streams.

As you can see, calculating APRs on adjustable rate products differs depending upon whether your initial rate is fully indexed or if it is discounted or premium. A good calculation tool is integral to achieving accuracy and compliance with these types of loans. In addition to properly calculating the APR for these loans, Regulation Z requires a number of other supporting disclosures that must be produced and given to the consumer. Section 226.19 of Regulation Z lists the requirements and disclosures.