Understanding Arm Indexes
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:
- 11th District Cost of Funds Index (COFI)- This index is the monthly weighted-average interest rate paid by 11th Federal Home Loan Bank (FHLB) District savings institutions for savings, checking accounts, advances from the FHLB, and other sources of funds. Historically, the COFI indexes has not fluctuated as rapidly as market interest rates (prime rate, the discount rate, or Treasury bill rates).
- 12-Month Treasury Average (MTA) - The 12-Month Treasury Average is also known as the Monthly Treasury Average. It is an average of the monthly yields of U.S. Treasury securities adjusted to a constant maturity of one year. This index typically fluctuates slightly more than the COFI index.
- Prime Rate - The prime rate is the interest rate charged by banks to their very best, most credit worthy customers. It is typically the lowest available interest rate. The prime rate is commonly used as the basis for home equity lines of credit (HELOC) interest rates. Its tendances are to rise more rapidly than it declines.
- Certificate of Deposit Index (CODI) - The basis for the CODI index is the interest rates paid on 3-month CD accounts. While the CODI index is a relatively stable index, it reacts more quickly to market conditions than do the COFI or COSI indexes.
- Certificates of Deposit Indexes - CD indexes are averages of secondary market interest rates for nationally traded CDs. Popular maturities for these indexes are one month, three months, six months, and one year. These indexes can be very volatile.
- Constant Maturity Treasury (CMT) - CMT indexes are weekly or monthly averages of United States Treasury securities. These are volatile indexes that react more quickly than the COFI or MTA indexes, but more slowly than CD indexes.
- Cost of Savings Index (COSI) - The basis for the COSI index is the interest rates in effect on World Savings (Golden West Financial Corporation) deposit accounts. The COSI index is the weighted average of the interest rates on deposit accounts. The COSI index is generally viewed to be one of the more stable indexes.
- London Inter Bank Offering Rates (LIBOR) - The LIBOR index is the rate of interest that London banks charge one another. Several different LIBOR rates can be used for ARM indexes including the one month, three month, six month, and one year. The six month is the most popular for use as an ARM index.
- Treasury Bill - T-Bill indexes are based on the interest rates realized on auctions of US Treasury bills of 1, 3, or 6 month maturity. T-Bill indexes move with the market and react quickly to market changes. The 6 month T-Bill index is the most frequently used for ARMs.
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:
- National Average Contract Mortgage Rate
- Semiannual Weighted Average Cost of Funds Index
- Freddie Mac's Required Net Yield (RNY)
- Fannie Mae's Required Net Yield (RNY)
- National Monthly Median Cost of Funds Index
- Quarterly Average Cost of Funds
- Semi-annual National Average Cost of Funds
- Federal Cost of Funds Index
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:
- The chosen ARM index (COFI, LIBOR, etc).
- The margin. The margins is basically a markup that is added to the index.
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.