One of the most important features of an adjustable rate mortgage is the index to which it is tied. If you plan to keep your loan for more than five years, it may be the most important feature, as all indexes do not react equally to rate changes.
There are two basic types of indexes. They are classified as leading and lagging. As the names imply, leading indexes react quickly to economic changes and are highly volatile. Lagging indexes adjust more slowly and do not reach the highs and lows of the leading indexes. Some of the indexes used to determine adjustable mortgage rates include the following.
• Constant Maturity Treasury (CMT)
• Treasury Bill (T-Bill)
• 12-Month Treasury Average (MTA)
• Cost of Deposit Index (CODI)
• 11th District Cost of Funds Index (COFI)
• Cost of Savings Index (COSI)
• London Interbank Offered Rate (LIBOR)
• Certificates of Deposit (CD) Indexes
• Prime Rate
To use an extreme historical example, in May 1981, the prime rate soared to 20.50%. The cost of funds index had also risen, but only to 11.43%. By May 1986, the prime rate had fallen to 8.25%, a 12.25% drop. The cost of funds index had also fallen, but only to
8.44%, a 2.99% drop. A mortgage lender’s success is largely dependent on interest rate trends, especially if making portfolio loans. A lender selling loans to secondary lenders will not worry about rate changes five years from now. The lender making a portfolio loan will usually want to use a leading index. If rates rise, the increase is reflected quickly in the loan rate. If rates fall, it is less likely that the borrower will refinance and the lender will lose the loan entirely.
When interest rates are high, a leading index may be to the borrower’s advantage. When rates are low, the lagging index is preferred.