The interest rate index is a published benchmark rate used by lenders to set adjustable rate mortgage (ARM) interest rates. It is determined by market forces and published by a neutral third party. For example, the London Interbank Offered Rate, or LIBOR, is managed by the ICE Benchmark Administration (IBA), and is based on five currencies: U.S. dollar (USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY) and Swiss franc (CHF). When setting ARM rates, mortgage lenders add the index to a margin, which is defined in the loan’s documents and agreed to by the lender and borrower.
There are many indexes used in setting ARM interest rates. Some of the most common include the LIBOR, CMT (Constant Maturity Treasury), COFI (11th District Cost of Funds Index), and MTA (Moving Treasury Average).
Adding the loan’s margin to its index produces what is called the fully-indexed rate. For example, if on the day that an ARM is supposed to reset, its index is 1.5 percent, and its margin is 2.75 percent, the fully-indexed rate is 4.25 percent.
Indexes are either based on average values or spot (snapshot) values. ARMs with indexes derived from averages tend to change more slowly, while those based on spot rates can change very suddenly. In general, ARMs based on average indexes tend to come with higher margins than those based on spot values.
Comparing ARM loans
When comparing ARM loans, their annual percentage rates can be helpful – not because they are realistic estimates of what a borrower would actually end up paying (no one knows what the index values will do in the future) but because they incorporate the fully-indexed rate into the calculation.
For example, if a borrower has choosing between a 1-year CMT ARM with a 3.00 percent margin or a 1-year LIBOR ARM with a 2.5 percent margin, he or she might look at a couple of things. If the 1-year LIBOR is at .71 percent and the 1-year CMT is at .20 percent, the CMT ARM’s fully-indexed rate would be 3.2 percent and the LIBOR’s would be 3.21 percent. Very close.
A borrower might also take a look at the average values of these indexes. In the last 15 years, the LIBOR’s average is 2.6 percent, which would produce a fully-indexed rate of 5.10 percent, while the CTM’s is 2.03 percent, which would produce a fully-indexed rate of 5.03 percent.
Both of these ARMs produce similar results, but the CMT loan has a tiny advantage.