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Which Adjustable Rate Mortgage Index Is the Best?

Which Adjustable Rate Mortgage Index Is the Best?

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


Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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