What Is a Fully Indexed Interest Rate?

A Fully Indexed Interest Rate Explained

A couple signs a contract with a mortgage banker.
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A fully indexed interest rate is a variable interest rate set at a fixed margin above a specific benchmark. The benchmark traditionally has been either the London interbank offered rate (LIBOR) or the federal funds rate.

The borrower’s credit score usually determines the size of the margin. Most loans have caps on how high variable interest rates can rise or fall over a given period of time.

Definition and Example of a Fully Indexed Interest Rate

A fully indexed interest rate is a variable rate that is set at a fixed rate above a reference rate. Common reference rates used are LIBOR, the federal funds rate, or the one-year Treasury rate. However, most LIBOR reference rates are scheduled to cease on Dec. 31, 2021, because of decreasing transactions and concerns by the international Financial Stability Board (FSB) about how LIBOR is being determined.

Fully indexed interest rates can vary considerably depending on the benchmark used or the size of the margin.

The margin for a fully indexed interest rate is usually calculated based on a borrower’s creditworthiness. Borrowers with high credit scores typically qualify for a lower margin over the chosen rate benchmark.

If you take out an adjustable-rate mortgage (ARM), then you’ll receive a fully indexed interest rate. With an ARM, you’ll receive a discounted index rate for the first year or so, called the teaser rate.

After a year or two, your ARM will adjust every five years or so. Once the rate changes, your ongoing fully indexed interest rate will depend on market conditions.

How a Fully Indexed Interest Rate Works

If you apply for a variable-rate loan, the rate is determined by two factors: an index and a margin. The index is a publicly available rate that the lender doesn’t control. However, your lender will decide which benchmark your index is based on. The index will change over time, depending on market conditions, causing your variable interest rate to rise or fall.

In comparison, the margin is the number of percentage points added to the index by your mortgage lender. The margin is based on your credit score, and this rate is locked in after you close on the loan.

So to determine your fully indexed interest rate, you’ll add the margin to the index.

The margin can vary quite a bit, depending on the lender, so you should seek quotes from multiple lenders. You can negotiate for a lower margin just like you would negotiate for a lower interest rate.

Types of ARMs

If you’re considering applying for an ARM, let’s look at three types you can consider:

Hybrid ARM

A hybrid ARM is a combination of a fixed-rate and adjustable-rate mortgage. You’ll have a fixed rate for a period of time, followed by an adjustable rate. A hybrid ARM comes with two numbers, and the first determines the length of the fixed-rate interest period. The second number specifies how often the interest rate will adjust after the introductory period is up.

For example, if you take out a 5/1 ARM, you’ll have a fixed rate for the first five years of the loan. After that, the interest rate will adjust annually until the mortgage is paid off.

Interest-Only ARM

An interest-only ARM allows you to make only interest payments for a set period of time. This introductory period usually lasts three to 10 years.

That means your monthly payments will be smaller until the intro period is up. After the initial term is over, your payments will be higher because you’ll start making payments on interest and principal.

Payment-Option ARM

A payment-option ARM lets you choose between several different payment options. For instance, you can make traditional interest and principal payments. That means your monthly payments will be higher, but you’ll pay off your mortgage faster.

You can also choose interest-only payments. With this option, your monthly payments will be lower in the beginning, but it will take you longer to repay the loan.

Finally, you can choose a minimum payment where you pay less interest each month. Paying less interest will reduce your monthly payments, but any interest you don’t pay is added on to the principal of the loan. So this option will increase your overall principal and will eventually lead to higher mortgage payments, sometimes called balloon payments, later on.

Key Takeaways

  • A fully indexed interest rate is a variable interest rate set at a fixed margin above the reference rate.
  • The reference rate is typically based on the federal funds rate, LIBOR, or the one-year Treasury rate.
  • The margin is the number of percentage points added to the index, and it’s often influenced by a borrower’s credit score.
  • If you take out an adjustable-rate mortgage (ARM), you’ll receive a fully indexed interest rate.
  • If you apply for an ARM, you can choose between a hybrid ARM, interest-only ARM, or a payment-option ARM.