The mortgage process understanding interest rate indexes

LIBOR. The most well-known interest rate index is the LIBOR, or London Interbank Offered Rate. Based on currencies from the United States, Great Britain, Japan, Switzerland, and the Euro, this index is commonly used in variable-rate loans, student loans, government and corporate bonds, and credit cards. Additionally, the LIBOR is used in lending between banks worldwide.  The British Bankers’ Association surveys banks about rates at which they could borrow money, averages the answers and reports them.  There are a variety of maturities associated with the LIBOR, ranging from overnight to a year, but the most used rate is the 3-month U.S. dollar rate.

CMT. Used exclusively in the U.S., the CMT, or Constant Maturity Treasury, is calculated using the daily yield curve of United States Treasury securities.  This index is used by many lenders to determine mortgage rates, and the one-year CMT is perhaps the most widely used for regulating ARMs in their annual rate adjustments. Because CMT stems from risk-free securities and mortgages are not without risk, many lenders add a 1% interest rate bump (their compensation) to cover the risk associated with mortgage lending.

COFI. For mortgages with monthly interest rate adjustments, the COFI (11^th District Cost of Funds) is the index often utilized. The 11^th District represents savings & loans institutions based in Arizona, California and Nevada and the Cost of Funds mirrors the interest those institutions paid on savings accounts, money borrowed by commercial banks, and advances to federal home loan banking organizations. Most of the index is based on interest paid to savings accounts, causing a lag behind more responsive market interest rates, and thus move more slowly.

MTA. The MTA index, Monthly Treasury Average, is another index used as the basis to set some adjustable rate mortgages. Also known at the 12-MAT, originates from a 12-month moving average of one-year constant maturity treasury bonds. “Moving average” means that short-term variances are not taken into consideration, focusing on the pattern created over the preceding 12-month period. This index can be very attractive when interest rates are fluctuating wildly, but in a period of falling interest rates, the slow-moving MTA doesn’t provide the bounce-back like other indexes do.

Since ARM’s aren’t often sold in the secondary market (combined in a group and sold to investors), they are marketed for exclusive use by the lender, and as such, offer much more flexibility for borrowers.  This can also mean generous qualification.

Now you know—if you are considering an ARM, you recognize different indexes and can ask informed questions from potential lenders. Having this background on indexes helps you to fully grasp the risks and benefits of an adjustable rate mortgage.