Adjustable Rate Mortgage Indexes
When a bank lends out money, it’s taking a risk. They screen their customers through application processes and evaluate your ability to pay back the loan by looking at your payment history and credit history. But no matter how good a borrower might look on paper there is still a risk involved in lending out money. They make up for this risk by charging different rates based on your financial past.
But the ability of the borrower to pay back the loan isn’t the only risk the bank takes. If you take out a fixed rate loan, the bank assumes all the risk on long-term interest rates. Because the rate is fixed it doesn’t change if the prime rate, or the rate that the bank has to pay to borrow money changes. Banks account for this risk by charging more for fixed-rate loans.
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With an adjustable rate mortgage you take on some of the risk of fluctuations in the interest rate. Lending institutions will usually entice you into an adjustable rate loan with a very low introductory rate. After an initial period where the rate is fixed, it will float based on a financial index.
The way that the rate floats with this index is another area where either you or the bank assumes some risk. When the rate is changed it can change either on an average or on a spot price. Since spot prices tend to be more volatile and averages tend to move more slowly, indexes based on averages tend to have higher rates.
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Whether an average or spot rate is used to calculate the interest rate usually depends on the index the loan is tied to. Monthly Average Treasury (MAT or MTA) and 11th District Cost of Funds Index (COFI) loans are based on averages. The MAT is also sometimes called the 12-month Treasury average,
If your adjustable rate loan is based on the London Interbank Offered Rate (LIBOR) it will most likely be based on a spot rate. A rate based on the prime rate or certificates of deposit yields will also be based on spot rates.
The constant maturity Treasury (CMT) index is a sort of hybrid. Its based on a short-term average that acts like a spot rate.
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