How ARM Rates Are Set
All mortgage loans, not just ARMs, are based on a particular index reflecting interest rates in the current market. Whatever loan you select, always check what index it's based on. For ARMs, the main indexes are the following:
Eleventh District Cost of Funds Index (COFI): This index determines what Western U.S. financial institutions are paying on deposits they hold. You need to be a bit careful with COFI-based loans. Even though their initial rates can be lower, they adjust monthly after three months and though you can cap your payment increase, rate hikes in excess of that cap will typically be tacked onto the back end of your loan, which means negative amortization — two words you want to avoid.
Twelve-month Moving Treasury Average (MTA or MAT): Each month, the U.S. Treasury calculates and publishes the average yield on a constant-maturity one-year Treasury bill for the previous month. The index is the average of the last twelve averages. This particular index tends to move slowly in reaction to fluctuations in short-term rates, so there are fewer surprises.
London Interbank Offered Rate (LIBOR): This index tracks the rates London banks charge each other for a one-month loan. It approximates the U.S. federal funds rate (discussed on page 184), and mortgage lenders like it because it tends to be a more reliable barometer of world economic events and a more ready indicator of where rates are heading worldwide.
Constant-maturity Treasury (CMT) Indexes: These indexes follow the weekly or monthly fluctuations in the yields for one-year Treasury bills. Most CMT-indexed loans are adjusted once a year. Hybrid ARMs tend to go CMT after they leave their fixed-rate period.
Always make sure your lender — or lenders, if you're comparing early offers — is taking pains to compare similar loan products right down to the index. In other words, a COFI-based ARM and a LIBOR-based ARM are two completely different animals. They might have distinctively different caps and other payment features even if they look the same in all other respects. Put loan officers on the spot with this.
With adjustable-rate loans, always check to see what margin is being charged over the index rate on the loan. Loans with higher margins hit their caps quicker, which means your loan might be resetting more often. You don't want that.
