Adjustable rate mortgages are like carrots to bunnies: they make you want to buy a house. The rate index is the key to figuring out if an adjustable-rate mortgage is a good deal.
Indexes: Putting Rates in Place
Lenders want your business and are willing to make loan products that are appealing to get it. Lenders sometimes offer adjustable-rate mortgages that have a lot of "carrot" at the beginning but nothing at the end. Most of the time, the initial interest rate on these loans is so low that it makes you look at mansions and other buildings that are way out of your price range. The problem with these loans is that after six months or a year, when the rate is tied to an index, it goes up by a lot.
Indexes are something special in the mortgage business. An index is a number that a bank uses to set the real interest rate on your loan. It is based on the average interest rates charged on a number of financial markets. This index looks at things like six-month certificate deposit rates at local banks, LIBOR, T-Bills, and other common financial markets or products. Let's look more closely.
Certificate Deposits: Also called "CDs," these are investments with fixed terms that you can get at your local bank. You agree to put a certain amount of money in the bank for six months, and the bank promises you a certain rate of return, such as 3%.
- T-Bills - Officially called Treasury Bills, T-Bills are the federal government's credit cards. Uncle Sam owes trillions of dollars on his debt right now, and he has to pay a certain interest rate on it. Lenders use the interest rate to figure out your ARM rates.
Cost of Funds Index: This index is a bit complicated, but it shows the average rates that banks in Nevada, Arizona, and California are using.
LIBOR, which stands for the London Interbank Offered Rate Index, is a popular way to figure out ARM rates. You might be wondering what London has to do with the real estate market in the United States. LIBOR is the interest rate that international banks charge on the London currency markets to borrow U.S. dollars. LIBOR rates change quickly, which can make it hard to predict how your mortgage's interest rate will change.
Why Indexes Are Useful
Indexes are important because they determine how much interest you will pay on your loan. Let's say you want a mortgage with a rate that changes based on the LIBOR index. Assume that the LIBOR rate is 2.2% when you fill out the application. The 2.2% is your starting rate of interest. If the LIBOR goes up by 1% in eight months, your loan will also go up by the same amount.
The index rate your loan is based on is not the interest rate you will pay. Instead, you must add the margin from the bank to the index rate. On top of the index rate, most banks will charge an extra 2% to 3%. Using LIBOR as an example, your loan's initial interest rate would be 2.2% plus whatever the bank uses as a spread. This means, of course, that you need to read the loan papers carefully to figure out how the game is played.
