Frequent readers of the newsletter are aware that I am a big proponent of Adjustable Rate Mortgages (ARMs) because they give you the lowest rates and for the least money. The reason that I am so high on these instruments is because most borrowers opt for a 30-yr. fixed rate mortgage that costs them about one and a half to two points more in rate than say a 5/1 ARM. And on average most people refinance within the first 4 years and or sell their home within the first 6 years. Thus, they have paid a 1-2% premium for something that they will never use. In fact, only 3% of all 30 yr. fixed rate mortgages are held to completion, which means that 97% of mortgagors who purchased 30 yr. fixed rate mortgages paid 1-2% more in rate for something they never used.
Incredibly, many borrowers mistakenly believe that adjustable rate mortgages only adjust upward. They can certainly adjust downward, too. As an example, I put my stepfather into a 5/1 ARM back in 2003 at 5.25% which guaranteed that his rate would remain fixed at 5.25% for the next five years, which it did. Since that time his rate has adjusted downward a number of times because the Index dropped. His rate right now is just a tad above 3%. He's had this loan for the past 8 years and given the economic climate it will probably remain under 5% for several more years.
Unfortunately, although a comparative bargain, they remain among the most misunderstood of all loan products, yet, they are really quite simple. The fixed component of an ARM is the MARGIN; it is in effect the lender's profit margin. It never changes. The INDEX is the variable component of an ARM; it is nothing more than a statistical indicator which changes with time and/or the cost of money. It determines how much the actual interest rate will increase (or decrease) over a specified period, be it a month, six-months or a year. It is also the subject of this month's newsletter.
As already touched upon, there are two components to an ARM loan: the INDEX and the MARGIN. When added together, the index and the margin, yield what is termed the fully-indexed or actual interest rate. So, for example, if one's indexed rate is 0.25% and one's margin is 2.75%, then the fully-indexed or actual rate is 3%.
In years gone by there were several different indexes. Among the little used acronymic indexes of yesteryear are the Cost Of Funds Index (COFI), the 12-Month Treasury Average (MTA), the Certificate of Deposit Index (CODI) and the Cost of Savings Index (COSI). The latter two no longer exist as the COSI was an index specific to World Savings which was acquired by Wachovia. Wachovia had the CODI as their specific index. But after acquiring World Savings, it was, in turn, bought by Wells Fargo Bank. The COFI and the MTA indexes were widely used for products with monthly interest rate adjustments, but they fell into disuse as Option ARM loans fell into disfavor. These days, for the majority of loans, there are just two indexes: the Constant Maturity Treasury (CMT) and the London InterBank Offering Rate (LIBOR). Each one has a distinct market and fluctuates differently. We will look at each of them in turn.
Constant Maturity Treasury (CMT) Index
This is the most widely used index. Roughly half of all ARMs are based on this index. It's used on ARMs with annual rate adjustments. It is also referred to as the 1-Year Treasury Bill (1Yr T-Bill) [see note], the 1-Year Treasury Security (1Yr T-Sec), or the 1-Year Treasury Spot index.
1-Year CMT Index vs. national average mortgage rate on 1-year CMT-indexed adjustable rate mortgages, 1992-2010. There are also 1-,3-,5-Year CMT Indexes which are based on the Average yields on U.S. Treasury securities. These indexes are the weekly or monthly average yields on U.S. Treasury securities adjusted to constant maturities of 1, 3, or 5 year(s) correspondingly. The CMT indexes are volatile and move with the market. They reflect the state of the economy, and respond quickly to economic changes.
The following CMT indexes are the most often used for ARMs:
1-Year CMT Index vs. national average mortgage rate (start rate) on 1-year CMT-indexed adjustable rate mortgages, 1992-2010
3-Year Constant Maturity Treasury index (3 Yr CMT)
This index is less popular than the 1-Year CMT. ARMs based on the 3 Year CMT will adjust every three years (3 Year ARMs). It may be referred to as the 3-Year Treasury Security (3Yr T-Sec) index.
5-Year Constant Maturity Treasury index (5 Yr CMT)
Same as the 3 Year CMT, but ARM loans indexed to the 5 Year CMT will adjust once every five years (the ARM's adjustment period is usually the same as the security's constant maturity). 1-, 3-, and 5-Year CMT, 1990-2010
London Inter Bank Offering Rates (LIBOR) Index
London Inter Bank Offering Rate (LIBOR) is an average of the interest rate on dollar-denominated deposits, also known as Eurodollars, traded between banks in London. The Eurodollar market is a major component of the International financial market. London is the center of the Euromarket in terms of volume.
6-Month LIBOR vs. 1-Yr CMT, 11th District COFI, 1990-2010
The LIBOR is an international index which follows the world economic condition. It allows international investors to match their cost of lending to their cost of funds. The LIBOR compares most closely to the 1-Year CMT index and is more open to quick and wide fluctuations than the COFI rate, as shown on the graph.
There are several different LIBOR rates widely used as ARM indexes: 1-, 3-, 6-Month, and 1-Year LIBOR. The 6-Month LIBOR is the most common.
LIBOR-indexed ARMs offer borrowers aggressive initial rates, but with increased volatility. With LIBOR ARMs borrowers are generally protected from wide fluctuations in interest rates by periodic and lifetime interest rate caps.
The CMT and the LIBOR indexes are the most widely used indexes for ARM loans. They track each other very closely. The shorter the time frame of the index, the more volatile it is (e.g. 1-yr. CMT vs. 5 yr. CMT). The CMT index is reflective of the state of the national economy; the LIBOR more closely mirrors global economic conditions.
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