ARM Index: What it Means, Types, Example

What Is an ARM Index?

The term “ARM index” refers to the benchmark interest rate to which an adjustable-rate mortgage (ARM) is tied. An ARM’s interest rate consists of an index rate value plus a margin. The index underlying the ARM is variable, while the margin is constant.

There are several popular indexes used for different types of ARMs, such as the London Interbank Offered Rate (LIBOR) or the federal funds rate. The interest rate on an ARM with its index is an example of a fully indexed interest rate.

Understanding ARM Indexes

ARMs are one of the credit market’s most popular variable-rate products. Interest rates are fixed for the initial period of the mortgage then reset based on fluctuations in the market during the remaining lifetime of the loan. Quotes for ARMs can vary, with the first number representing the years charging a fixed rate. A 2/28 ARM would have a fixed rate for two years followed by an adjustable rate for 28 years. A 5/1 ARM could have a fixed rate for five years followed by an adjustable rate that resets every year. This makes these mortgages ideal when borrowers believe that mortgage rates will fall.

The loan is based on an indexed rate plus a margin during the variable rate period. An open variable rate increases or decreases when a change occurs with the indexed rate. If a loan has specific terms for resetting the interest rate, such as at the end of each year, then the interest rate will be adjusted to the fully indexed rate at the time of the adjustment.

The index to which an ARM is tied can make a difference over the life of the mortgage. While it is an important factor, borrowers should consider more than the index when choosing an ARM. Many other variables, such as the margin and the interest rate cap structure, are important considerations. Other factors that are important include the starting rate and the length of the loan.

Types of ARM Indexes

There are several different types of ARM indexes. Each has its own characteristics that set it apart from the others. The following are some of the most popular.

Prime

The prime rate is set by the Federal Reserve and used by most financial institutions, including banks and credit unions. This is the interest rate that most commercial banks charge their most creditworthy clients. It serves as the basis for other interest rates, including those for mortgages and loans.

This index is typically used in the pricing of short- and medium-term loans, or for adjustments at set intervals on long-term loans. The rate is consistent on a national basis, allowing consumers to make an apples-to-apples comparison regardless of where they live. This means that the prime rate is the same in California and Maine, so mortgagors can compare how competitive their ARMs are in both states. The margins on the loan and whether or not the interest is set below the prime rate all become elements in comparing loan offers.

LIBOR

As a global index, the LIBOR is a barometer for the global economy and is used by investors who operate internationally. This index is based on the interest rate charged among London-based banks for borrowing transactions among them. The LIBOR index is often used as an ARM index to cover intervals that can be one month, three months, six months, or one year.

Monthly Treasury Average

The Monthly Treasury Average (MTA) Index is a popular ARM index, especially for those who want to hedge against rising interest rates. This index is a moving average calculation with a lag effect. This means that if interest rates are expected to rise, a mortgage tied to the MTA index may be more economical than one tied to an index without a moving average calculation like the one-month LIBOR index. But while it’s a good bet when interest rates rise, it doesn’t bode so well when they fall.

One-Year T-Bill

Many ARM loans use this index. This index is based on the auction results for 12-month Treasury Bills (T-Bills) held by the U.S. Treasury that are offered every week. Due to the highly fluid nature of the yields of the one-year T-bill—because of the weekly auctions—the index is much more volatile.

ARM Index vs. ARM Margin

ARM index and ARM margin represent two different elements of an adjustable-rate loan. The index rate, as mentioned, is the benchmark rate that’s used to determine the rate for your loan. This rate can adjust up or down over time, in accordance with changing market conditions.

Margin represents the number of percentage points by which your loan rate can increase once the fixed-rate period ends. ARM margin is established in your loan agreement and doesn’t change once the loan closes. Where the margin is set is determined by the lender and the terms of the loan. The fully indexed rate for an ARM is equal to the margin and the index added together.

Example of an ARM Index

Understanding how an ARM index works is important when deciding whether an ARM is appropriate, based on both its short- and long-term affordability. Say you’re planning to buy a home and looking at an ARM that follows the one-year T-bill as its index. Your loan particulars are as follows:

• Mortgage amount: $300,000
• Mortgage term: 30 years
• Fixed-rate period: Five years
• Fixed period interest rate: 3.25%
• ARM index: 1.891%
• ARM margin: 3.00%

The loan has an annual adjustment period with a 2% initial adjustment cap, then a 1% adjustment cap thereafter. Your estimated monthly mortgage payment for the interest and principal during the fixed-rate period would be $1,306. With a fully indexed rate, your payment would increase to $1,549. Your total interest expense for the life of the loan would be $243,081.