Adjustable rate mortgage (ARM) indexes

When choosing an ARM, it's important to consider its index in order to help protect yourself from interest rate fluctuations.

When you take out an adjustable rate mortgage (ARM), you know that the interest rate will one day change. So it’s important to know how that interest rate will be adjusted when the day arrives. This is done using an index, and understanding indexes can help you choose the mortgage that will cost the least in the long run.

What is an index?
An index is a published interest rate based on the returns of investments such as U.S. Treasury securities. The rates for these investments change in response to market conditions, so an index tends to track changes in U.S. or world interest rates.

How ARM interest rates are calculated
To calculate the interest rate on an ARM, a lender starts with a particular index rate and then adds a predetermined number of percentage points (called the margin) to get the final rate. Since the margin usually stays the same throughout the life of a loan, changes in the index rate dictate how your mortgage rate will change at each adjustment date (the specific date -- often every one, three or five years -- upon which your ARM rate is adjusted).

As an example, say your mortgage starts with the following:
Index = 4.5%
Margin = 2.5%
ARM rate = 7%

At your adjustment period, say the index has risen 1 point, to 5.5%:
Index = 5.5%
Margin = 2.5%
ARM rate = 8%

Different types of indexes
Lenders use several different types of indexes to set ARM rates and these index rates can differ significantly. Some indexes are relatively stable while others tend to be far more volatile. Often, ARMs based on more stable indexes carry a higher margin than those based on indexes that are more apt to react quickly to market conditions.

Generally, it’s better to have a slow-moving index when interest rates are rising and a fast-moving index when they are falling. However, these index rates only become a factor on your adjustment date, and interest-rate trends are hard to predict.

The indexes most often used by lenders are:

• 12-Month Treasury Average (MTA): This index, also known as the 12-Month Moving Average Treasury index (MAT), is based on a moving average of the monthly yields on U.S. Treasury securities. It’s adjusted once a month and moves slowly, lagging the other indexes.
• 11th District Cost of Funds index (COFI): This widely used index is calculated monthly based on the weighted average of interest rates paid on savings and checking accounts by institutions in the 11th Federal Home Loan Bank District (consisting of banks based in Arizona, California and Nevada). Its rate also tends to change slowly.
• Constant Maturity Treasury indexes (CMT): These indexes follow the average weekly or monthly yields on U.S. Treasury bills. They are more attuned to events in the economy and can change rapidly. The one-year CMT is widely used for mortgages with annual rate adjustments.
• London Interbank Offered Rate indexes (LIBOR): These are based on the average interest rates London banks borrow funds from each other. They are more volatile than the COFI or MTA indexes. However, LIBOR-based mortgages tend to have low initial rates. They also tend to have lifetime and periodic interest rate caps to protect borrowers from spikes in the index rate.

Other indexes used by lenders include the Treasury Bill index (T-Bill), Certificate of Deposit Index (CODI), Cost of Savings Index (COSI), and Bank Prime Loan or Prime Rate index. Knowing which index a mortgage is based on can give you a better idea of your future risk from interest rate fluctuations.

Related Topics:

• Down payments
• Interest rates
• Mortgage Refinance
• Mortgages