A mortgage index is a benchmark interest rate that reflects general market conditions. Lenders combine the mortgage index with the margin, which they determine, to generate your interest rate on an adjustable-rate mortgage.
Let’s take a look at what mortgage indexes are, how they work, and what they mean for you.
Definition and Examples of Mortgage Indexes
A mortgage index is an interest rate that fluctuates based on general market conditions. When you apply for an adjustable-rate mortgage (ARM), the lender will use the mortgage index as a starting point for your interest rate. It will then add on a specific percentage, known as the margin, to arrive at the total interest rate for your loan. Think of the index as the base rate, and the margin as the lender’s markup.
- Alternate name: ARM index
Banks and other lenders can rely on any one of multiple mortgage indexes when creating your loan. Your lender will decide which index to use when you apply for the loan, and the index generally will not change, even after your loan closes. Common indexes include:
- Federal Funds Rate
- Discount Rate
- Prime Rate
- 10-Year Treasury Security
- 6-Month LIBOR
- Fannie Mae 30/60
- Overnight LIBOR
- 1-Year Treasury Security
- 6-Month Certificate of Deposit (CD)
- 11th District Cost of Funds (COFI)
Banks are also free to create their own indexes. Wells Fargo, for example, uses the Wells Fargo Cost of Savings Index (COSI) for its adjustable-rate mortgages.
How Mortgage Indexes Work
Let’s say that you’re planning to buy a new home, but you don’t think you’re going to live there long-term. As a result, you decide that an adjustable-rate mortgage is right for you, since the introductory interest rates are lower than those of a fixed-rate mortgage.
You’ve already found the right property and signed a sales agreement. Now, you’re working with your lender to complete your loan application. Your credit score is excellent due to a long history of on-time payments and low credit usage.
After a deep dive into your finances and a few conversations about your work history, your bank chooses a mortgage index and combines it with the margin to create the fully indexed rate, or the interest rate for your loan.
If you’re satisfied with the loan options that your lender gives you, feel free to go ahead with the process. However, your high credit score leaves you room to negotiate on the margin that they’ll charge you—and worst case, you can stick with their initial offer. In addition, just like fixed-rate loans, adjustable-rate mortgages and their interest rates can vary significantly from lender to lender. It’s always a good idea to shop around for interest rates before settling on one bank.
Adjustable-rate mortgage agreements include fine print that you should read carefully. For example, make sure you know how often interest rates adjust and whether there are any minimum or maximum rates. These rules could mean that even if the index decreases, your fully indexed rate doesn’t.
What Do Mortgage Indexes Mean for You?
As a consumer, you have no control over mortgage indexes. Your lender chooses the index for your adjustable-rate mortgage, and market conditions determine the index rates.
But you can control whether and how you prepare for the effect mortgage indexes can have on your adjustable-rate mortgage. ARMs can be appealing to buyers because they often offer lower introductory rates than fixed loans, and those rates can last for three, five, seven, and even 10 years. Once that initial period ends, your loan will start using the fully indexed rate: the index plus the margin. If you don’t plan on keeping the loan beyond that initial period, you may not need to worry about the index.
But if you do plan to keep your property longer than your initial period, remember that your rate will now adjust up or down based on market conditions at specific intervals. The most common adjustment interval is once per year. Make sure you’re prepared to budget for larger mortgage payments in case the index increases.
You’ll see ARMs advertised using two numbers, such as 5/1. The first number is the initial period and the second is the adjustment interval.
- Mortgage indexes are based on general market conditions.
- Lenders use a mortgage index, paired with a margin, to create a fully indexed rate for an adjustable-rate mortgage.
- Adjustable-rate mortgages may be appealing at first glance, but make sure to understand the fine print about how your payments will adjust based on the index before signing an agreement.