One of the major components of an adjustable-rate mortgage is index, which is difficult to understand because of its different types and unpredictable nature. An ARM interest rate is made of two components – index and margin. While the margin is fixed, the index rate is set by market forces and is published regularly in many available sources.
What are the other components of an Adjustable-rate mortgage?
An indexed ARM is different from a discretionary ARM in that the former uses the current index value to calculate the interest rate at the time of origination or adjustment. If it is assumed that the value of the index to which the rate is tied does not change from its initial level, then the situation is referred to as a no change scenario.
What is the difference between indexed ARM and discretionary ARM
Indexes differ in how they react to the changes in market. Some are based on spot rates and are more volatile, changing the ARM rates tied to it quite abruptly. Others are based on average rates and can move more slowly, making the changes in ARM payments not as steep. Note that the margin is typically higher on an index based on average rates.
Most hybrid ARMs with annual rate adjustment use CMT when they enter their adjustment periods. Published by the Federal Reserve Board, the Constant Maturity Treasury is based on the average yield of a variety of Treasury securities adjusted to a one-year maturity. Though the rates on CMT-indexed mortgages move up and down rather quickly, they are usually adjusted once in a year.
The cost of funds for the 11th district of the Federal Home Loan Bank System, which consists of banks based in Arizona, California and Nevada are taken as an index and referred to as 11th District Cost of Funds Index, or simply COFI. Based on average rates, COFI can cause the ARM rates based on it to respond slowly to the market fluctuations. However, a borrower runs the risk of negative amortization since the rate is adjusted every month but the monthly payment is adjusted once a year.
The London Interbank Offered Rate, abbreviated as LIBOR, is based on the rates at which London banks pay to borrow one another’s reserves. It is a kind of indexes based on spot rates, and is more volatile than COFI. The rate may be adjusted every month, every six months or annually, creating one-month, six-month or 12-month LIBOR, respectively.
The U.S. Treasury publishes every month the average yield on a constant-maturity one-year Treasury bill for the previous month. The 12 MTA or 12 MAT, which is an acronym for the 12-month Treasury average, refers to the average of the last 12 averages published by the U.S. Treasury. The ARM rate based on 12 MTA is adjusted every month, but the monthly payment might be adjusted monthly or annually.
The Cost of Savings Index is based on the deposit account rates of the federally insured depository institution subsidiaries of Golden West Financial Corporation (GDW). The COSI is rather stable and not as volatile as one-month LIBOR.