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

The margin

The amount of the margin stays fixed over the life of the loan. To reiterate, the value of the margin stays the same. The index value is the variable feature on the Option ARM (or any adjustable rate mortgage for that matter). So, more important than the start rate on an Option ARM is the amount of the margin. Please, please, please ask what margin value the lender/mortgage broker is quoting you. You must inquire what the amount of the margin is as it is not disclosed on the Good Faith Estimate or Truth-in-Lending Disclosures! At least not directly. It is buried in the annual percentage rate which makes it difficult, if not impossible, to clearly ascertain. This is a key factor you should be comparing. For example:

Let's say ABC Mortgage quoted you a 1% start rate with a 2.5% margin at a 1% origination fee.

CBS Bank also quoted you a 1% start rate with a 3.0% margin and also a 1% origination fee. CBS Banks's margin is 1/2% higher, which makes your interest rate 1/2% higher. On a $200,000 loan amount, that equates to a minimum of $1,000 extra in interest payments annually! I say minimum because if you made the minimum payment of $643.28, your payment would be insufficient to cover the interest portion due on the loan and that difference will be added to your principal balance known as negative amortization (detailed explanation to follow in an upcoming post). Then you will be assessed more interest on your deferred interest or negative amortization!

I can not emphasize enough the importance of obtaining the lowest margin possible at the same cost and with no prepayment penalty. What I mean by that is if all the lenders are quoting you a 1% origination fee (then you are comparing apples to apples), you know the best deal is the one with the lowest margin. The lower the margin, the lower your interest rate. Though prepayment penalties are a subject for a future post, I mention this now as one of the lenders ploys may be to indicate they can get you a lower margin if a prepayment penalty is added to the terms of the loan program. Please do not let anyone talk you into a prepayment penalty. One never knows what life has in store for us and it is best to not be hindered with a long and expensive prepayment penalty. Sometimes short term prepayment penalites (1 year or less) are do-able. More to come on prepayment penalties and how they are calculated in an upcoming post.

Option ARM Components

Remember -- Option ARM's are not created equally! The components to consider when comparing Option ARM's with various lenders are:

1. The initial start rate
2. The margin
3. The index
4. Life-of-loan cap
5. Periodic cap
6. Annual payment cap
7. Maximum amount of negative amortization which can accrue
8. Payment options
9. Loan origination fees
10. Prepayment penalties

Let's determine how these various components factor into the equation:

The initial start rate:

The sole purpose of the initial start rate is to determine the amount of your minimum payment for the next 12 months. Initial rates can vary from a low of 1% (I have been told there is a lender that advertises a start rate of 1/2%, but I have not personally encountered that lender as of yet!) to as high as 4.5% dependent upon such factors as owner occupied vs investment property, a single family dwelling vs units, low loan-to-values (LTV) vs high LTV's, and others. Many lenders promote a 1% start rate. Given a loan amount of say $200,000, that would equate to a payment of $643.28 (based on a 30-year amortization; 40-year amortizations are available with some lenders). The $643.28 figure is the minimum payment which must be made for the next twelve months.

Option ARM's

Most people are very familiar with Option ARM loan programs. They have been around since the 1980's and have gained popularity. This program can be great as it offers the most flexibity compared to many other loans on the market. Unfortunately, though, most people do not really understand how this loan program works. In upcoming posts, I will attempt to provide a thorough explanation of the components of the Option ARM to enable you to make the determination if this is the right loan for you and your current situation.

Until next time...