A mortgage index is a measurement that mortgage lenders in the United States (US) use to determine the interest rate on an adjustable rate mortgage (ARM). ARMs are mortgages that do not have a fixed interest rate. An ARM usually begins with a fixed-rate introductory period that can last either months or years. When the introductory period ends, the loan is then subject to periodic changes over the life of the loan. A mortgage index determines how the rate will change on an ARM and is a measurement of interest rates that move in response to market changes in the economy.
Lenders determine the rate on an adjustable rate mortgage in two parts. The mortgage index is the adjustable part that is determined by the movement of the economy. A lender typically chooses which mortgage index to use, but has no control over the movement of the index.
The second part of the rate is the margin, which is the fixed part of the rate. It is usually a few percentage points added onto the index. The margin is determined by the lender and does not change over time. When the lender adds the index rate plus the margin, the result is the fully indexed rate, or the interest rate on the loan.
Some of the most common ARM indices include the Constant Maturity Treasury (CMT), the 12-month Treasury Average (MTA), the London Interbank Offered Rate (LIBOR), and the 11th District Cost of Funds Index (COFI). Before taking out a mortgage loan tied to a mortgage index, buyers generally should become familiar with how the index has fluctuated in the past. Current and historical rates on indices may be found in newspapers or on the Internet.
Although the indices change daily, the interest rate of an ARM changes at intervals set by the mortgage company. Usually, the rate will adjust at a set number of months or years. Once the rate changes, the mortgage payment will adjust accordingly until the next adjustment date — when the index rate goes up, the payment also goes up. In theory, this would mean that the interest rate on a loan would go down when the index rates go down, although this is not always the case. Some loans do not allow payments to go down even when the index rate goes down.
There are often limitations written into a loan that keep the rate from following the index too closely. A periodic adjustment cap keeps the loan from adjusting more than a set number of percentage points at a single adjustment. Generally, a lifetime cap limits the percentage points the rate can move over the lifetime of the loan.
In many European countries, there are no fixed-rate loans. All mortgage loans are adjustable rate mortgages and work differently from ARMs in the US. Adjustable rate mortgages called discretionary ARMs offer few of the protective measures that ARMs in the US do — there are no caps and no indices tied to them. Rates may be adjusted at any time, for any reason, at the discretion of the lender. The only requirement is advance notice.