Reset rates apply to many different types of loans. Here’s how they impact your loans and payments.
Definition and Examples of a Reset Rate
A reset rate is the change in a variable interest rate dependent on market conditions. Fixed interest rates don’t change over the life of your loan. Variable interest rates, however, fluctuate. You might start out with a low interest rate, but it could go up if benchmark rates change. Variable interest rates may be tied to the London Interbank Offered Rate (LIBOR), the federal funds rate, or another type of index. These rates are the benchmarks for setting interest rates. When lenders set the variable interest rate on a product—like a mortgage or a credit card—they use these rates as a starting point and add their own margin on top of it for profit. For example, say a mortgage lender uses a benchmark rate of 3% and then adds a margin of 2 more percentage points on top of that. Your interest rate would be 5% (3 + 2 = 5). If the benchmark rate changes, the variable interest rate will follow shortly after. While variable interest rates tend to be lower for many borrowers compared to fixed interest rates, they don’t always stay that way.
How Does a Reset Rate Work?
Any variable interest rate is set to change when a reset rate comes up. This can happen with credit cards, student loans, auto loans, and—most notably—home loans. Adjustable rate mortgages (ARMs) use variable interest rates. When the rate “resets,” you’ll get a new interest rate and then a new payment. The date when it resets is known as the mortgage reset date. For ARMs, you might see a change after the first year or at the five-year mark depending on your home loan agreement. You might also see a reset rate in bonds. Like other types of reset rates, bonds will change their interest rate based on the market value. These tend to happen on certain dates, not necessarily on or around when the federal funds rate changes. A reset rate could also change based on the company’s performance to protect the investors of that bond. When calculating your reset rate, there are two figures you should be aware of: the index and the margin.
Index: This is the LIBOR, the federal funds rate, or another benchmark figure.Margin: This is the percentage increase set by your lender. It’s what the lender will tack onto the index rate to earn a profit.
Your margin rate is specific to you based on your credit history. The better your credit, the lower your margin rate. If you have excellent credit, you might only see a minimal change when your reset rate comes along. Your lender will also detail in your agreement when a reset rate will take place. For instance, in a three-year ARM, you won’t see a change in your interest rate for the first three years of your mortgage. After that, your lender will send you a letter detailing any changes that are coming and when those changes will happen. Sometimes this is 30 days out from your next payment. It can be longer or shorter depending on the lender and the terms of your agreement.
