February 7, 2000
"Could you tell me
which ARM index is best for the borrower, and why?"
An ARM's
index is used to set the interest rate, subject to any rate caps, after
the initial rate period ends. For example, a 3/1 ARM has an initial rate
of 6.5 percent, which holds for three years. At the end of three years,
the rate adjusts to equal the index's current value, plus a margin. If the
index after three years is 5 percent and the margin is 2.75 percent, the
new rate would be 7.75 percent.
The current value of an index
should be readily available from a published source, and it should not be
influenced in any way by the lender writing the ARM contract. All of the
indexes listed below meet both of these criteria except one. This is
called the Cost of Savings Index or COSI, which I view as unacceptable for
this reason.
Other things the same, you want
the index that will have the lowest value after the initial rate period
ends. That is easier said than done, but if you follow the guidelines
below the odds will be in your favor.
When an ARM has an initial rate
that holds for a year or less, the best index is the one that has the
lowest value now. This rule does not apply to ARMs with initial
rate periods of two years or longer.
Avoid indexes that tend to be
higher than other indexes most of the time. The bank prime rate should be
avoided for this reason, unless it is accompanied by a much smaller
margin.
The two most widely used indexes
are the Treasury One-Year Constant Maturity series, and the 11th District Cost of Funds Index (COFI). Since 1977, they have averaged out
about the same. The COFI, however, is much less volatile. This benefits
the borrower when rates are rising because COFI doesn't rise as much as
other indexes. But it works against the borrower when rates fall. Because
you can refinance when rates fall, the COFI generally is the preferable
index.
A variant of the Treasury One-Year
Constant Maturity series, called 12MTA, is the average of the most recent
12 monthly values. It fluctuates less than the unadjusted one-year series
and is almost as stable as the COFI.
Several other indexes average out
about the same and show about the same volatility as the Treasury one-year
series. These include 6-month CDs, 1-month LIBOR and 6-month LIBOR.
A number of Treasury series other
than the one-year series are also used as ARM indexes. The Treasury bill
series are a little better than the one-year series because they are a
little lower most of the time. The 2-year and 3-year series are not as
good as the one-year series because they are a little higher most of the
time.
In making a decision about the ARM
index, remember that a less favorable index can be offset by a smaller
margin. My index rankings below show the difference in margin that you
should receive as compensation for accepting a less favorable index. They
should be viewed as informed guesses and nothing more. Here are the
rankings:
- COFI, 12MTA, Treasury
Bills (12 months and shorter): (0)
- Treasury One Year,
6-month CDs, 1-month and 6-month LIBOR: (0.15)
- Treasury Two Years:
(.040)
- Treasury Three Years:
(0.65)
- Bank Prime Rate:
(1.30)
To illustrate: If I am offered
one of the ARMs in the
top group
with a 2.75% margin, I would want the margin on an ARM using the
Treasury one-year series to be 2.60% or less, and I would want an ARM
using the bank prime rate to be 1.45% or less.
Sources for finding the
most recent value of an index are shown in ARM
Indexes.
Copyright Jack Guttentag
2002
