About one in five mortgage applicants nowadays gets an adjustable-rate mortgage, or ARM. The hardest-to-understand element of an ARM is the index.
When you get an ARM, two main factors determine the rate you pay: the index and the margin. The index is a rate set by market forces and published by a neutral third party. The margin is an agreed-upon number of percentage points that is added to the index to determine your rate.
A thorough mortgage shopper will run across a bunch of acronyms to denote various ARM indexes, such as COFI, LIBOR, MAT and CMT. Each index responds at its own peculiar pace to the economy's ups and downs.
Indexes can be divided into two broad categories: those based upon rate averages and those based upon more volatile spot rates. There is some overlap between the two categories. ARMs indexed to average rates tend to move more slowly, in rather gradual steps, whether the markets are rising or falling. ARMs based on spot rates go up and down abruptly.
Larry Goldstone, president of Thornburg Mortgage, a portfolio lender that focuses principally on ARMs, says ARMs based on averages tend to have higher margins than ARMs based on spot rates.
Someone who gets an ARM indexed to rate averages "gets one benefit and one drawback," Goldstone says. "The benefit is that, in a changing rate environment, an average index will move more slowly, so the payment changes more slowly. The drawback is that the margin typically is higher, and so the rate you pay is higher."
Indexes based on average rates include the 11th District Cost of Funds Index, or COFI, and the 12-month moving Treasury average, (variously called the MTA and the MAT, for monthly average Treasury).
Of indexes based on spot rates, among the most popular is the LIBOR, one-month London Interbank Offered Rate, for London Interbank Offered Rate. Then there is the constant maturity Treasury, or CMT, index, which comes from a short-term average that acts more like a spot rate. Other spot indexes are based on the prime rate and yields on certificates of deposit.
One way to compare ARMs with different index options is to look at their fluctuations in a graph. That will help you understand how rapidly and how much the rates change.
Here is a rundown of some of the popular types of adjustable-rate mortgages, how they work and who they are suited for:
11th District Cost of Funds Index, or COFI, index: Rates on COFI-indexed mortgages move up and down slowly. With most COFI-based loans, the rate is adjusted every month and the monthly payment is adjusted once a year. This means that some borrowers can end up owing more than they borrowed if their payments don't cover all the interest due, a phenomenon called "negative amortization."
COFI-based loans are indexed to the cost of funds for the 11th district of the Federal Home Loan Bank system. The 11th district consists of banks based in Arizona, California and Nevada. The cost of funds index is a weighted average of the interest that member banks pay on money they borrow, mostly on customers' checking and savings accounts.
Anyone who has had a savings, money market or interest-bearing savings account knows that those rates are low and move tortoise-like. The COFI (pronounced "coffee") is calculated at the end of every month for the previous month, so it lags the overall market. The COFI's slow, lagging pace benefits borrowers when rates are rising, but not when rates are falling.
12-month Treasury average, MTA or MAT, indexes: Rates on ARMS indexed to the 12-month average of the one-year Treasury bill are usually called the "12 MAT" or "12 MTA." Every month, the U.S. Treasury calculates and publishes the average yield on a constant-maturity one-year Treasury bill for the previous month. The 12 MAT index takes the average of the last 12 averages.
Like the COFI, the rate on a 12 MAT is adjusted every month. Depending on the loan program, the monthly payment might be adjusted every month or once a year.
Rates indexed to the last 12 monthly averages for one-year Treasuries move slowly. "If interest rates were to go up 100 basis points tomorrow," says Goldstone -- in other words, if they rose 1 percentage point -- "that index would go up only one-twelfth of 1 percent the next month. And then the second twelfth the next month, and so on."
The 12 MAT index reacts slowly to fluctuations in short-term rates and smoothes them out.
London Interbank Offered Rate, or LIBOR, indexes: The LIBOR (pronounced "LIE-bore") tracks the rates at which London banks pay to borrow one another's reserves. It fluctuates more rapidly than the COFI or 12 MAT. The LIBOR is sort of a rough equivalent of the federal funds rate in the United States, but it is set by the market, not a government entity.
There are various LIBOR maturities. The most common are one-month, six-month and 12-month. Typically, a one-month LIBOR will be based on the rate for a one-month loan between London banks, and a mortgage based on the one-month LIBOR would be adjusted every month. A six-month LIBOR would be based on the rate for a six-month loan between London banks, and the mortgage based on that rate would be adjusted every six months.
"It is an index that has wider coverage and wider sensitivity to the world, rather than just the domestic market," says Anthony Hsieh, CEO of HomeLoanCenter.com. Lenders like the LIBOR because it "is very sensitive to both up and down markets, on the rise and the decrease," Hsieh says. The borrower shares the risk with the lender.
Constant-maturity Treasury, or CMT, indexes: These indexes follow the weekly or monthly fluctuations in the yields for one-year Treasury bills. The rates on CMT-indexed ARMs move up and down rather quickly. Most CMT-indexed mortgages are adjusted once a year.
CMT-indexed loans are among the most popular ARMs. Hybrid ARMs -- home loans that have a fixed rate for the first few years, then adjusts annually -- usually turn into CMT-indexed mortgages when they enter their adjustment periods.
If you're paying attention, you might have noticed that CMT-indexed mortgages are based on a weekly or monthly average and adjust once a year, while MAT-indexed mortgages are based on an annual average and adjust every month. It's one of the quirks of the mortgage business.
Mortgage bankers say it's important that a borrower understand ARM indexes. But there are other things to consider: the margin, the caps on how high the rate can go and other features.
Some loan programs give you three or four choices for each month's payment: You might have the option of making a "minimum payment" that might not even cover the interest accrued in the past month (the aforementioned negative amortization), an interest-only payment, a fully amortizing payment or a full payment plus some extra to be applied to principal.
Other features to look for include the ability of a home's future buyer to assume the mortgage and the capability to modify the loan -- to switch to another index without having to go through an expensive refinance.
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