The IndexIndex & Margin – What Does it Mean?
Two factors determined how often the rate can change. Both the frequency of payment and rate adjustments play into how often the rate changes. The interest rate changes are a function of the index added to the margin of the borrower’s loan. Using the index determined the future rate changes of an ARM. The borrower should look for the index which is regularly published in a source accessible to the public and be beyond the lender’s control. If the index is linked to the lender’s performance, or risk experience the lender could theoretically increase the index whenever he/she needs to make more money to cover losses.
Numerous indices are used to determine how interest rates can change on adjustable-rate mortgages. Some of the more common and popular indices and how often they adjust can be found below:
Index: LIBOR (London Interbank Offered Rate)
Adjusts: One month, six months or 12 months depending on the loan program.
Definition: Average interest rate charged to banks in the London Interbank System when borrowing money from one another with ranging maturities.
Index: COFI (11[SUP]th[/SUP] District Cost of Funds Index)
Adjusts: Monthly or Once a year depending on the loan program
Definition: Weighted index of the cost member banks (in Arizona, California & Nevada) pay on money borrowed such as customer checking and savings accounts.
Index: COSI (Cost of Savings Index)
Definition: A stable index that is the weighted average of interest rates on deposit accounts (savings) at federally insured depository institutions.
Index: CMT (Constant Maturity Treasury)
Adjusts: Once a year
Definition: Follows the weekly or monthly fluctuations in the yield on one-year Treasury bills
Index: MAT/MTA (12 month Treasury Average)
Definition: Average yield on US constant-maturity one-year Treasury bill adjusted every month by the US Treasury that reacts slowly to short-term fluctuations.
Index: Prime Rate (The Fed, US prime rate)
Definition: Short term interest rate used in the banking system of the United States used by various lending institutions and is the basis for rates on most short-term loans/lending instruments (Fed funds target rate + 3)
The index is one component used when figuring the new rate of an adjustable rate mortgage. The other key piece that also must be factored in when figuring the new rate is the margin. Using the two variables, the new rate is determined by the following equation:
INDEX + MARGIN = NEW RATE
The margin is set by the lender and is the amount above the index that the interest rate can adjust at the time of the adjustment. The result of the index plus margin formula is the new interest rate. This is why you need to analyze your new loan to make sure it’s not artificially high.
The representation of the real interest rate of an adjustable rate mortgage is the margin. Considering the real cost is important because it goes beyond the discounted rates that are offered on most ARM loans, especially those ARMs that are short-term.
A discounted rate indicates that the points paid in conjunctions with the loan artificially reduce the interest rate to attract more borrowers. Looking at the equation that uses the index plus the margin gives what is known as the Fully Indexed Accrual Rate (FIAR). This provides a more accurate representation of the actual costs of the loan rather than simply using the discounted rate.
The Lowest Margin Offers the Lowest Cost
Every loan may offer a different margin; this is the critical part of analyzing the ARM. If the margin is higher it means that regardless of what happens to interest rates, the customer who chooses the loan with the higher margin will be paying a higher interest rate over the life of the loan. This is true of all ARM products. ARMs continue to evolve as legislators and the secondary market adjust to the current financial environment and economy in the U.S. As the housing industry struggles to pull itself back to health I’m sure that further changes are to follow.