What You Need To Know About Your Adjustable Mortgage Benchmark Indexes

Adjustable mortgages or ARMs are a kind of home loans in which the rate of interest paid on the principal amount is determined by the performance of a specific benchmark. Several benchmark indexes are used to calculate interest rates for adjustable mortgages. At least some of these are proprietary benchmarks fixed by individual lending institutions.

If you are planning to apply for an ARM, you will definitely want to know how these indexes affect your mortgage payment.

Overview of benchmarks

The most common benchmark indexes used to set ARM rates are the London Interbank Offered Rate (LIBOR), the 11th District Cost of Funds Index (COFI) and the One-Year Constant Maturity Treasury (CMT).

COFI

This benchmark is calculated on the basis of the weighted average of interest rates paid by member banks of the Federal Home Loan Bank of San Francisco to holders of their checking and saving accounts. The interest rate is adjusted every month. Adjustable mortgages which are associated with COFI reset once a year. Here the interest rates can increase every month, but COFI adjusts mortgage rates only once. This can lead to negative amortization. That means your monthly EMI will not be enough to cover your interest.

CMT

The CMT benchmark index is calculated on the basis of the average 1-year yield of the 4 most recently auctioned Treasury bills.

LIBOR

This benchmark is based on interest rates paid by London banks when they borrow money from one another. This is the most commonly used benchmark for determining ARM interest rates.

Several other benchmarks are also used to decide mortgage interest rates. While the names of these benchmarks are not exactly important, a borrower should know how these benchmarks work.

How benchmarks work

Both CMT and COFI are based on averages. As a result, rates change slowly. This is good when interest rates are rising rapidly. But when interest rates are falling, this can be disadvantageous. LIBOR can rise rapidly, so borrowers may see massive increases in their monthly mortgage payments.

Why benchmarks are important? 

Borrowers can choose an ARM that is linked to a specific index. Of course, they cannot decide which index the lender will use, but they can choose a lender that uses the index of their choice.

While selecting a benchmark, you should know whether the benchmark is based on averages. You should also know how often it adjusts and how much it can adjust. Is there the risk of negative amortization? These are a few questions you should ask.

Before the housing bust, adjustable mortgages accounted for 20% of all mortgages. But after the housing bust, their share dipped to 5%. Now most of the proprietary benchmarks have faded away and lenders have also become more conservative. Still, the borrower needs to be vigilant.

Should you choose an ARM?

Adjustable mortgages are ideal for people who plan to pay off the loan before the rates reset. They can help borrowers when interest rates fall. ARMs tend to have lower interest rates during the initial period of the loan. That is why many people prefer them to standard fixed rate mortgages.

However, borrowers who intend to live in the house for a long time should stay away from ARMs. This is especially true in the case of borrowers who are choosing an ARM to afford the monthly payment. While this strategy will work during the initial period; when the loan adjusts, rising rates can force borrowers to default.