The Veridian Blog

Indices are used for Adjustable Rate Mortgages as a method of computing the variable interest rate that the borrower pays on outstanding balances.  In nearly all ARM loans, the variable rate is computed periodically as the sum of the current index value plus a fixed margin.  For example, Borrower John’s LIBOR-based ARM rate would be today’s 1-year LIBOR index of 0.9644 plus a fixed margin of 2.25% (as determined when the loan was originated), for a total fully-indexed rate of 3.2144%.  This sounds great, as it is a historic low, but remember that indices are variable and hence can, and will, go up at some point in the future.  This rate will adjust automatically on a yearly, semi-annual or monthly basis so the borrower’s monthly payment will also change automatically.

For hybrid-ARM loans that offer an initial fixed period, the terms will specify limits, or CAPS for how much the variable rate can  move once the loan converts, from period-to-period, and during its lifetime.  This is typically defined in three numbers: an initial cap, a period cap and a lifetime cap.  Borrower John’s caps are likely going to be “5/2/5”, which indicates an initial cap of 5% over the starting rate, 2% maximum increase from year-to-year, and a 5% cap over the starting rate at any time during the life of the loan.

The most common ARM indices used in the United States are:

1.      CMT – this is also known as the “1-year Treasury” or “1-year T-Bill”, it is the most widely used index.  Roughly half of all ARMs are based on the CMT with annual rate adjustments. 

2.      LIBOR – the London Inter Bank Offering Rate is an average of the interest rate on dollar-denominated deposits, also known as Eurodollars, traded between banks in London.   It is an international index which follows the world economic condition and is generally more volatile than the CMT and the COFI.

3.      COFI – the 11^th District Cost of Funds index reflects a weighted average interest rate paid by the 11^th Federal Home Loan Bank District savings institutions for savings and checking accounts, advances from the FHLB and other sources of funds.  COFI is the slowest moving and most stable of all ARM indices.

4.      Prime Rate – is the rate charged by nation’s largest banks for short-term loans to their most creditworthy customers.  Many home-equity loans and lines of credit, credit cards and auto loans are tied to the Prime Rate as published in the Wall Street Journal – which factors in at least 75% of the 30 largest U.S. banks.

5.      National Average Contract Mortgage Rate – formerly a popular index in the 1980’s, this represents the weighted average of initial mortgage interest rates paid by home buyers reported by a sample of mortgage lenders for loans closed for the last 5 working days of the month. 

6.      COSI – the Cost of Savings Index – is based on interest rates that a particular bank pays to individuals on certificates of deposits.  Since the merger of World Savings and Wachovia, only two indexes published by Wachovia and Wells Fargo are used consistently.

Lenders will usually offer lower rates on ARM programs because they are shifting the interest rate risk to the borrower.  For more information on ARMS and the different indices, email us or see: http://www.armindexes.com/index-types.html