Index Margin

On the anniversary date of the ARM loan's original closing, the interest rate is adjusted—which will have a subsequent effect on the monthly payment.

When the lender adjusts the ARM loan's interest rate, they must do so according to the agreement set forth in the original promissory note signed at the closing. The standard method for adjusting ARM interest rate is to add the defined "margin" to the current "index" rate.

The margin is a constant amount—usually 2.750 to 3.250 for most conforming ARM loans—which is added to the index to determine the new interest rate. The margin is established by the loan program's note signed at the closing. The margin stays the same throughout the life of the loan. Borrowers entering into an ARM loan should know beforehand what the margin will be.

It is the index that changes and underlies the ARM loan's adjustments. The interest rate on ARM loans is tied to the rates of securities, financial papers or a basket of indicators that adequately reflect market conditions. This indicator rate is normally called the index rate. The index may be one of many widely recognized measurements of lending costs.

The most popular and commonly known are the U.S. Treasury Bills and the Prime Rate. The following are the four most commonly used indices:

  • US Treasury Bills. The T-Bill index rate is based on the yield prices established by the daily sale and trade of the U.S. Treasury Bills on the financial markets. There are actually several T-Bills (2-year, 6-month, 3-year, etc.), but the one-year T-Bill is the most commonly used index.
  • Prime Rate. The prime rate is the rate that banks charge to their best customers, usually commercial. The prime rate is actually higher than other indices because it factors in the bank's profit margin. Although, each bank sets its own prime rate, they tend to be uniform as they are all based on the same market data.
  • Cost-of-Funds Index (COFI). The COFI index is calculated by each of the Federal Reserves' regional districts, the most popular of which is the 11th District. The Cost-of-Funds index is a monthly survey of the cost to the banks of the money they have at their disposal. Thus, the COFI index takes into account current CD rates, savings account rates and other costs that banks must pay for funds.
  • London InterBank Offered Rate (LIBOR). The LIBOR index has become the index of choice for non-conforming lenders, especially with sub-prime (B/C/D/E) credit loans. The LIBOR rate tends to remain close to—though slightly higher—than the T-Bills.

The index is a publicly available and trusted mechanism that measures changes in the economy (generally) and the mortgage industry and real estate market (specifically). The index measures fluctuations in the financial markets on a continuous basis. When the adjustable-rate loan is signed, the loan's promissory note will indicate the specific index to be used.

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