Index rates are a key component of the interest rates you pay for adjustable rate mortgages (ARMs) used to finance or refinance a home, as well as home equity loans and other mortgages.
Indexes also impact interest rates for credit cards, auto loans and other forms of credit that comes with an adjustable rate.
An adjustable rate mortgage comes with two primary components, the index rate and the margin.
It is the index rate that puts the “adjustable” in the ARM, because indexes are variable and change over time.
If the index rate moves up, so typically does your interest rate. Likewise, if the index rate goes down, your monthly payment drops.
The margin, a few percentage points added to the index rate, typically remains the same over the life of the loan. Margins can, however, differ from one lender to another and they can be smaller for those with excellent credit, larger for those with poor credit.
In addition to the index and your margin, your ARM mortgage payment also can be affected by loan terms, which can include certain limits or caps on how high or how low your rate can adjust over the life of the loan. Loan terms also can dictate how often your rate will adjust and by how much it can change during each adjustment.
Indexing the indexes
There are a variety of common interest rate indexes used to set ARM interest rates. Here’s a look at the most common.
• Prime Rate – The “Prime Rate,” also referred to as the National, Federal, U.S. or Wall Street Journal Prime Rate, even California or New York Prime Rate, is the rate set by the largest banks in the nation. The Prime Rate is typically the rate charged when the banks lend money to their most creditworthy customers.
The rate moves up or down in lockstep with the Federal Funds Rate and is typically 300 basis points (3 percentage points) above the Federal Funds Rate. As of March of 2012, the Federal Funds Rate target was 0.25 percent, the Prime Rate was 3.25 percent.
The Fed Funds Rate is an average of all of the separately negotiated rates that the banks charge one another to borrow from each other.
Prime Rate fluctuations can impact the interest rate on many adjustable-rate credit cards, home equity loans, and some ARMs.
• Treasury Rates – Uncle Sam periodically sells Treasury securities (notes or bonds) to finance government operations and to pay the national debt. Securities sold on the open market can be traded. Because they are backed by the full faith and credit of the U.S. Treasury, they represent a rate at which investment is considered risk-free.
While the bonds carry a set interest rate, called a “coupon rate,” buyers and sellers buy them at varying prices. Since the price of the bond varies, but the interest rate and final amount of principal to be repaid remain fixed, the yield, expressed as a percentage, can vary.
Treasury bonds of different lengths have different yields with shorter bonds carrying lower rates and longer bonds carrying higher rates. Longer-term bonds like the 3-, 5-, 7- and 10-year Treasury typically serve as indices for commercial real estate mortgages and for some residential ARMs. The 1-year Treasury is an especially popular index, used for many ARMs which adjust their rate each year.
• LIBOR Rate – The London Interbank Offered Rate (LIBOR), similar to the Federal Funds Rate, is a rate at which banks borrow U.S. dollars from each other through London’s financial market. It serves as the benchmark for a number of esoteric derivative investments and for many ARMs.
• COFI Rate – The Cost of Funds Index (COFI) reflects the weighted-average interest rate paid by 11th Federal Home Loan Bank District (Arizona, California, Nevada) savings institutions for savings and checking accounts.
The index is used for ARMs and other variable-rate loans. COFI usually lags market interest rates in both up and down markets. That means loans tied to this index rise and fall more slowly than rates in general.
These rate indexes are ubiquitous throughout the global economy. Understanding how they originate and how they fluctuate will help you understand why your cost of credit fluctuates.
You can even track these indexes to predict what your debt will cost in the future.
• The Federal Reserve’s Federal Funds Rate can also impact mortgage interest rates. Read “Two more years of 4% interest rates?” to learn how.