Comparing mortgages? If you are looking at an adjustable-rate mortgage (ARM), you might be missing something.
Your mortgage comparison has probably covered the starting interest rate, and you should know to take into account the initial reset period and subsequent reset intervals. Perhaps you have even amortized the fees into an APR calculation. However, when dealing with ARMs, there is one element of a mortgage comparison that people too often overlook: the index that will be used to reset the mortgage rate. Understanding that index and the dynamics behind it may be an important factor in choosing the right mortgage, and in monitoring your loan over the life of the mortgage.
What Is the Index?
An ARM has an interest rate that changes over time, according to market conditions. Those market conditions are defined by what's known as an index, which is a published measure of current market levels. ARM rates are calculated by adding the value of an index to a margin, which is set by the lender and agreed to by the borrower. If the value of an index is 4.5 percent, and the loan's margin is 2.0 percent, the interest rate is 6.5 percent.
You are probably familiar with at least one index – the Dow Jones Industrial Index. It's simply a compilation of the prices of many stocks and is used by many to judge the health of American companies. If you want to see today's Dow Jones numbers, they are pretty easy to find online. You can find other indexes easily too, once you know what to look for.
Major Types of Indexes and Their Characteristics
There are numerous specific indexes used for ARMs by different lending institutions, but these are some of the major types:
US Treasuries are freely-traded, highly-liquid securities with yields that change daily according to the market's perception of the direction of interest rates. In particular, Treasuries are very responsive to news concerning inflation and economic growth. Note that various maturities of Treasuries can be used as ARM indexes, for example, a one-year Treasury or a five-year Treasury. It matters how long or short the index maturity is.
Longer-term Treasuries typically have higher yields than shorter-term ones, but that does not necessarily mean a longer-term index will lead to a higher mortgage rate, because loan margins can vary. History from the Federal Reserve shows that yields on Treasuries of different lengths tend to move in the same direction at the same times, but yields on longer-term Treasuries are likely to have a more extreme reaction to upturns in interest rates. Thus, a longer-term Treasury index could expose your ARM to more severe interest rate risk.
An ARM index might be based on an average of rates currently being charged for other loans. Examples include LIBOR, an internationally-followed index based on rates at which banks lend to one another, or the National Average Contract Mortgage rate, which is an index of rates currently being charged by mortgage lenders. Unlike Treasury-based indexes, lending-based indexes will be sensitive to concerns about credit conditions, and thus may not fall as far during periods of economic weakness as Treasury-based indexes.
Cost-of-funds indexes, such as the Federal Cost of Funds Index tracked by Freddie Mac, are based on what it costs banks to gain access to the funds they use for mortgage lending. At one time, cost of fund indexes were often based on rates paid on bank deposits, but ARMS based on those indexes have gone out of vogue. Those based on federal interest rates will tend to behave more like the Treasury-based indexes described above.
Before you take out an adjustable-rate mortgage, you should know what type of index it has, and if possible learn something about both its current level and its history. This is important because while you can choose which ARM loan rate you want to sign up for today, the loan's index will be determining the loan rate you pay in the future.