All adjustable rate mortgages (ARMs) have indexes used in calculating future interest rate changes. An index is the "base rate" from which your new interest rate is built at each adjustment period. Ideally, you want an index that is stable, widely available for verifying, and simple to understand. Since most new ARMs begin with a "teaser" rate to help you qualify, be sure to understand your index to avoid "sticker shock" after your first adjustment.
How an Index Works
At every adjustment period -- 6 months, one year, two years -- specified in your mortgage, your lender recalculates your interest rate based on your index and your margin. Your margin, also specified in your mortgage note, is the percentage added to your index value to determine your interest rate for the coming period. For example, if your index equals three percent 45 to 60 days before adjustment date, and your margin is four percent, your new interest rate will be seven percent.
An index should be a reasonable and well publicized independent third party percentage rate. For example, a popular index is the LIBOR (London Interbank Offered Rate). Published daily, this rate tends to be stable and outside of mortgage lender control. Other popular index rates are the 11th District Cost of Funds (COFI), U.S. Treasury Bill (T-Bill), and Constant Maturity Treasury (CMT) rate. Along with the LIBOR, these indexes account for around 80 percent of all ARMs today.
Index Versus Margin
While your mortgage index is important, your margin should generate equal attention. While an index is an independently set rate, your margin is created by your mortgage lender. Margins of two, three and four percent are common. However, if you have marginal credit scores, you might be offered margins of five, six or seven percent, which will compute to an unwelcome interest rate regardless of your index rate. Fight for the lowest margin you can get.
The "Best" Index?
Because the U.S. economy typically influences European interest rates, also, any of the aforementioned common index options are usually reasonable and fairly stable. However, other indexes have historically caused some problems. For example, should your mortgage have "Bank Prime Rate" as an index, be aware that this rate can move up quickly in inflationary periods. However, even the most common and stable indexes can -- and will -- move upward and downward in relation to the overall strength or weakness of the U.S. economy.
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