Adjustable Rate Mortgages: The Index Rate and Its Significance

Adjustable-rate mortgages are a popular form of home loan that links the interest rate of your loan to a particular index. ARM loans are popular among home buyers because they provide a lower initial interest rate and make homes more affordable during the introductory period. After a predetermined period of time, the initial rate resets to follow the index it’s tied with.

How the Index Affects Your Interest Rate

The main benefit of an ARM loan is that when interest rates fall, you will end up with smaller monthly payments when the loan resets. The flip side of an ARM, of course, is that when index rates rise, so does the interest rate on the loan–thus, monthly payments go up and take a bigger and more painful bite out of your wallet.

The key is the rate movement of the ARM, either up or down, which the index pegged at. There are multiple indexes out there with which an ARM interest rate can be linked.

Banks, credit unions and other financial institutions will link their interest rates to several prominent financial indexes. Some of these indexes are the Federal Funds rate, the discount rate, the overnight LIBOR, Freddie Mac 30/60, Fannie Mae 30/60, 6-Month LIBOR, 10-Year Treasury Security and the WSJ Prime Rate. These indexes are updated regularly, and your bank or lending institution can link the interest rate to one of these indexes.

If you want to get a sense of how your monthly payments on your adjustable-rate mortgage are going to change, you should find out which index your loan will be linked to, preferably before you apply for the mortgage.

Before you take out a mortgage loan, whether it’s an ARM, a fixed-rate mortgage or any other kind of home loan, make sure you discuss your plans and your options with a financial adviser. He or she can provide you with invaluable advice and suggestions on what is best for you.