The Index

The index is the variable factor on any given Adjustable Rate Mortgage loan program. There are a variety of indices tied to various adjustable rate loan programs. To list a few:

1. COFI (Cost of Funds Index)
2. MTA (12 Month Treasury Average)
3. CODI (Certificate of Deposit Index)
4. LIBOR (London Inter Bank Offering Rate)
a) 1 mo LIBOR
b) 3 mo LIBOR
c) 6 mo LIBOR
d) 1 yr LIBOR

The explanation of how each index is compiled and their respective performance is beyond the scope of this post. However, for a better description and historical data on each index, visit:

http://mortgage-x.com/general/indexes/default.asp

Nonetheless, a few things to keep in mind while selecting your index is some indexes are weighted, such as the COFI and CODI. This means these indexes will not react as quickly to the current economy (or market as we call it in the mortgage industry). For example, the COFI index is the Weighted Average Cost of Funds for Savings & Loans in the 11th District (which includes California, Arizona & Nevada). The COFI index is published on the last Friday of each month. So, when the index is published on Friday, November 24, 2006, this index is reflecting the cost of funds for October. This index will be used to establish interest rates for ARM's where the interest rate is adjusting in either January 2007 or Febuary 2007 as lenders are required to give a minimum of a 45 to 60 day notification advising the borrowers of the pending rate change.

Because weighted indexes are slower moving, this can work to your advantage when rates are increasing. Conversely, it will work to your disadvantage when rates are decreasing.

The LIBOR indexes and MTA index responds more quickly to the economy/market. Sometimes this is referred to as being more volatile. The longer the period covered for the index, the more "stable" it is. For example, the 12 month MTA is a rolling 12-month average of the Monthly Treasury Average whereas the 1 month LIBOR covers a 1-month period.

Consider these attributes when selecting your index. If the lender you are dealing with does not offer choices, seek out other lenders or mortgage brokers until you find an index you are comfortable with.

Once you are familiar with the index that is offered on your particular Option ARM, the important thing to know is that the current index value plus your margin equals your interest rate (also known as the fully indexed rate). Typically, with the monthly Option ARM, your initial start rate (in our illustration, 1%) is in effect for one month. In the second month, the interest rate begins to change monthly. The interest rate is determined by adding the margin, let's use a 2.75% margin, to the current index value, we'll use the MTA index (which is probably one of the more commonly used index for the Option ARM loan programs). Based on today's value, the MTA index is 4.758%. To determine the interest rate, add the margin, 2.75%, to the MTA index, 4.758%, and you will arrive at a fully indexed rate of 7.508%. The interest rate of 7.508% will be used to determine the amount of interest paid on your principal balance for the month that was specified in your notification.

For a quick snapshot of current index values, I use the following website:

http://www.lioninc.com/market_snapshot