Fully Indexed Interest Rate: What it Means, How it Works, FAQs

What Is a Fully Indexed Interest Rate?

A fully indexed interest rate is a variable interest rate that is calculated by adding a margin to a specified index interest rate, such as LIBOR or the Fed Funds rate. Fully indexed interest rates can vary broadly based on the assigned margin above that baseline rate or what maturity term the underlying index is set at.

Fully Indexed Interest Rate Explained

Generally, a standard indexed rate is often the lowest rate a bank will charge to its highest credit quality borrowers. It is also often the rate banks charge for lending to other banks. Popular indexes for indexed rates include the prime rate, LIBOR, and various U.S. Treasury bill and note rates.

Fully indexed interest rates are used for variable-rate credit products. The margin on a fully indexed interest rate product is determined by the underwriter and based on the borrower’s credit quality. Adjustable-rate mortgages (ARMs) are one of the most common fully indexed interest rate products.

Margin

Lenders typically assign a margin to most variable rate products, and the margin is added to a specified index rate to serve as the fully indexed interest rate charged to borrowers on credit balances. In a variable fully indexed interest rate product, the margin will typically remain the same throughout the life of the loan with the interest rate adjusted based on changes to the standard indexed rate.

Margin is determined in the underwriting process. Higher credit quality borrowers can generally expect to be assigned a smaller margin while lower credit quality borrowers will pay a higher margin.

For example, if the fully indexed interest rate on a personal loan is tied to the six-month LIBOR index with a margin of 3%, then the rate would be 10% if the six-month LIBOR index were at 7%. If the six-month LIBOR index were to increase to 8%, then the new fully indexed interest rate would be 11%.

Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) are one of the credit market's most popular variable rate products. An adjustable-rate mortgage can be preferrable when a borrower believes mortgage rates will fall. These mortgages begin with a fixed rate for a specified number of years and then follow with a variable rate that resets based on the loan terms.

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.

During the variable-rate timeframe, the loan will be based on an indexed rate plus a margin. An open variable rate will increase or decrease 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 Bottom Line

A fully indexed interest rate plays a key role in a number of financial products, from adjustable rate mortgages to credit cards. Understanding how it works can help you anticipate potential changes in your monthly payments toward these type of loans.