If you have an adjustable-rate mortgage, the interest rate that you pay can shift over time. The rate is based on a published rate known as the mortgage index, or index rate, plus an additional factor called a margin. Before you agree to a loan, it's important to understand how your adjustable-rate mortgage works and how the rate could vary.
TL;DR (Too Long; Didn't Read)
An index rate is a published interest rate that's used to determine the rate of an adjustable-rate mortgage.
Adjustable- and Fixed-Rate Mortgages
Some mortgage loans used to buy houses and other property are fixed-rate mortgages. With those, the rate that you pay is constant over time, meaning that your mortgage payments are more predictable.
Other mortgages are what are called adjustable-rate mortgages. With these, your rate can fluctuate after an initial introductory period, generally based on prevailing interest rates. The exact rate or set of rates that is used to determine the rate you pay for the mortgage is called an index rate. The index rate is specified in the terms of your loan. There is generally an additional constant factor called a margin that is added to the index rate to determine your mortgage rate.
Understand Your Loan Terms
The loan terms should also specify factors like how often the mortgage rate can change, how the lender will notify you of fluctuations in the rates, whether there's a maximum rate you may have to pay and whether there's a minimum rate on the loan. Make sure you understand the terms and the risk that you're taking on with an adjustable-rate mortgage as you shop and before you sign any papers.
Remember that in addition to mortgage costs, you'll also generally be responsible for property taxes, homeowners' insurance and maintenance on your property, so you'll want to take those costs into account as well. You may also be required to pay condo fees if you own a condominium or homeowners' association dues if you live in a community with such a group in place.
In order to make sure that the lender receives a minimum amount of interest, some loans also feature what's called a prepayment penalty, which charges you a fee for refinancing your mortgage or paying it off too quickly. This can also be worth understanding if you think you may refinance or pay your loan early, particularly with an adjustable-rate mortgage because you might shop around for better terms if your rate rises substantially.
Index Rate Possibilities
Different adjustable-rate mortgages have different index rates, and since different interest rates can fluctuate in different ways, these can affect how much you ultimately pay on a loan. While central banks like the Federal Reserve take steps to set and regulate interest rates, they fluctuate according to economic conditions that can be hard to predict in advance.
Some common index rates are the yield on a one-year treasury bill, a security issued by the U.S. Treasury Department, aggregate indices showing how much sets of banks are paying on deposits and a rate called the London Interbank Offering Rate, or Libor. The current Libor rate specifies how much big banks are charging each other for certain loans.
Different potential index rates tend to go up or down at different times, and some fluctuate faster than others. It can be difficult to predict the market even a few years in advance, so it may not be worth worrying too much about how different potential index rates will fluctuate over the often decades-long life of a mortgage, but it is a factor you can consider when shopping for a loan.
- Investopedia: ARM Index
- Consumer Financial Protection Bureau: For an Adjustable-Rate Mortgage (ARM), What are the Index and Margin, and How Do They Work?
- Investopedia: Mortgage Index
- Bankrate: Adjustable-Rate Mortgages: Learn the Basics of ARMs
- Consumer Financial Protection Bureau: What is the Difference Between a Fixed-Rate and Adjustable-Rate Mortgage (ARM) Loan?
- Investopedia: Prepayment Penalty
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.