Understanding adjustable rate mortgage indexes

September 27, 2011 – Adjustable rate mortgages (ARMs) have an ugly reputation after the subprime crisis put them in the spotlight. However, they are still a good option for some borrowers for the right reasons.

ARMs become popular in the early 80’s when fixed rates were up in the 15 or 16 percent range. To escape high rates, buyers began choosing ARMs that carried lower starting rates. ARM rates go up and down according to a nationally published index, the most common being the One-Year Treasury Index. Some even offer a conversion option to switch to a fixed rate sometime during the term.

ARMs are good to consider when rates are expected to fall, or if the buyer plans to keep their home for only a few years. However, predicting interest rates is difficult for even the most skilled economist. ARMs do carry a rate cap, which is the highest rate by which it can climb during the loan’s term. ARMs could rise dramatically, causing a large increase in monthly household expenses.

Here’s an explanation of indexes that are most often used to price them:

One-Year Treasury
The Treasury Security indexes are calculated by the Treasury Department and reported by the Federal Reserve. These indexes have both weekly and monthly values, but most lenders use the weekly values in their adjustable rate mortgages (ARMs). These indexes reflect the state of the economy, and respond quickly to economic changes.

The most commonly used index is the One-Year Treasury Security. It’s used on ARMs with annual rate adjustments. Confusion can arise when some lenders use the term “One Year Treasury Bill.” Most one-year ARMs are actually tied to the Constant Maturity of the One-Year Treasury Security.

Six Month LIBOR
LIBOR stands for London Inter Bank Offer Rate. It’s the rate of interest at which banks offer to lend money to one another in the wholesale money markets in London. Money can be borrowed overnight for a period in excess of five years.

The LIBOR rate is used as a base index for setting rates of some ARM programs. Rates are set each day at 11 a.m. (London time) by leading banks, and posted each morning in The Wall Street Journal.

There are four types of LIBOR rates: one-month, three-month, six-month and one-year. However, the most common quote for mortgages is the six-month LIBOR.

11th FHLB District COFI
This index is primarily used for ARMs with monthly interest rate adjustments. The 11th District represents the savings and loans associations and banks headquartered in Arizona, California and Nevada. The cost of funds reflects interest paid by institutions for savings accounts, FHLB advances, money borrowed from commercial banks, and other sources.

Since the largest part of a cost of funds index is interest paid on savings accounts, this index lags market interest rates. As a result, ARMs tied to this index rise and fall more slowly than rates in general. However, such ARMs often have payment caps, but no month-to-month interest rate caps.

2 thoughts on “Understanding adjustable rate mortgage indexes

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