All Adjustable rate mortgages (ARMs) use an index as the basis for setting the interest rate that the borrower pays. Many people often wonder which index may be most advantageous. The simple answer to that question is - it depends. Each interest rate index has advantages and disadvantages, and reacts differently in times of rising interest rates or declining interest rates. It is important to understand what the major indexes are, and what their various characteristics are.
ARM Mortgage Indexes
Following is a list of the major indexes used by lenders to set the interest rates on adjustable rate mortgages:
CMT, COFI, and LIBOR are the most commonly used ARM indexes, and are used by over three quarters of all ARMs. Other lesser used indexes include:
How the Indexes are Used to Set ARM Interest Rates
The interest rate on adjustable rate mortgages fluctuates after some predetermined period (from one month to ten years). After that initial period, the interest rate is adjusted at a predetermined interval. Most ARMs adjust annually but there are other adjustment intervals some as short as one month.
Two things are used to set the interest rate that the consumer will pay on their loan:
At each adjustment interval, the lender looks up the rate for the chosen index and adds to that index the margin to obtain the interest rate that the consumer will be charged. For example, if the index has an interest rate of 5%, and the margin is 2%, the consumer would be charged an interest rate of 7%.
Which ARM Index to Choose
Market conditions can make the answer to this question difficult. However, it is generally accepted that the COFI index is among the best of the ARM indexes, and that the prime rate index is among the worst. The rest fall in between those two extremes. There is disagreement, even among the experts, about which other indexes are toward the better end of the spectrum or the worse.There is some consensus that the 1-month CMT, 6-month CD, 1 and 6 month LIBOR, and the MTA are toward the good end of the spectrum, while the 3-year CMT is toward the bad end.
Some individuals try to predict interest rate trends and either choose a leading index, one that moves with the market and does better in times of declining rates, or a lagging index, one that moves slower than the market and does better in times of rising rates. It should be noted that even industry experts can do poorly trying to predict interest rate trends.