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Lenders use
various indices to adjust interest rates as economic conditions
change over time. Lenders add a certain number of percentage points,
called a margin, to the index to establish the interest rate
borrowers must pay.
LIBOR
London
Inter-Bank Offered Rate (LIBOR)
LIBOR is the
rate of interest that member banks of the British Bankers'
Association charge when they lend money to one another in the
wholesale money markets in London, somewhat similar to our Fed Funds
Rate. In fact, the LIBOR tends to closely track the US Fed Funds
Rate. LIBOR is a standard financial index that is used globally and
in US capital markets, and the Wall Street Journal publishes the
index on a daily basis. In general, changes in the LIBOR have tended
to be smaller than changes in the Prime Rate. There are several
LIBOR maturities much like U.S. Treasuries, but the 1-month and 6
month are the most readily used and available LIBOR indexes for
mortgage loans. Although they are becoming increasingly more common
in use for consumer loans and ARM¹s, LIBOR Indices have
traditionally been a reference figure for corporate and commercial
financial transactions.
Summary:
Over the past
several years, the LIBOR has slowly begun to replace the more
commonly used 1-year T-bill index as the index of choice for hybrid
ARMs such as 3-, 5-, 7-, and 10 yr products to determine rate at
their adjustment periods. It is very established and dependable, yet
it does carry a risk of slightly larger volatility when the US
Dollar fluctuates. This is due to the fact that LIBOR is a European
based index and reacts to the dollar strengthening or weakening much
like the Euro becoming more valuable or less valuable to the dollar
in slowing and expanding economic situations. The shorter term LIBOR
products are great in a Fed easing cycle, but should be used
cautiously and possibly avoided when the Fed is hiking short-term
rates, as the index could rise very quickly. In these situations, a
better option may be the 3 or 5 year Hybrid LIBOR ARMs.
Ideally
Suited for:
This index is
ideally suited for the more aggressive borrower on the 1 month and 6
month products as it will tend to fall faster than any other index
and yet also rise as fast as the Fed hikes in rising markets and
sometimes even faster depending on currency conditions. The key here
is the margin. Some investors offer buy downs into the low 1% range
for this product and can make it a very attractive choice when
looking at a ten year chart with your customer. Hybrid ARMs such as
the 3-, 5-, 7-, and 10-year products that use the LIBOR for the
change rate at adjustment time can have a wide variety of use
depending on your clients' desired length of time in their home and
other specific needs and goals.
MTA
Monthly
Treasury Average (1 year MTA)
This index is
determined by averaging one-year Treasury bills each month over the
prior 12 month time period. This is an index used to set the cost of
various variable-rate loans, particularly adjustable-rate mortgages.
The use of the 1-Year MTA as a loan index is relatively new. The MTA
generally fluctuates more than the 11th District Cost-of-Funds Index
(COFI see below), although they both track each other
closely.
Note:
The MTA index
is often used in what are commonly referred to as "Option ARMs".
This product type can create terrific cash flow and payment
stability for your customer in the early years of the loan, but
requires a great presentation from you and education on the
consequences of the different payment options, such as negative
amortization.
Summary:
The one year
MTA is the most popular index for ARMs when looking for stability
and low volatility. Very predictable in a one year or less outlook
for your customer, and has a very clear track record of rising
slower than other popular indexes with competitive
margins.
Ideally
Suited for:
This index is
ideally suited for mid-level to even conservative borrowers that are
short to mid term dwellers in their home. The MTA is great in a
steady but rising interest rate environment when measuring against a
fixed rate. As long as the spread between current fixed rates and
the fully indexed rate on the MTA is a full one percent or greater,
an ARM tied to this index can be a very good strategy.
COFI
Cost of Funds
Index (COFI)
This is a
monthly cost-of-funds index (COFI) reflecting the weighted-average
interest rate paid by a particular Federal Home Loan Bank District
savings institution on savings and checking accounts. The 11th
District is the one most commonly used, which covers Arizona,
California and Nevada. The COFI index is published on the last day
of the month, and reflects the cost of funds for the prior month.
COFI usually lags behind market interest rates in both up and down
markets, which means that loans tied to this index rise and fall
more slowly than interest rates in general.
Summary:
The COFI is a
stable index that is still available but is not used as widely as it
once was due to the massive consolidation in the S&L industry
over the past decade. With fewer and fewer S&L’s the bottom line
costs of the big ones that are left are lower and more stable, which
does not bode well for an investor in an upward or volatile market.
Since a consistently higher margin is tied to this product it will
be less attractive for your customer.
Ideally
Suited for:
This index is
ideally suited for a niche borrower with some qualifying challenges
who is comfortable with a slightly higher effective rate. Great for
a stable to rising interest rate environment.
1 Year T-Bill
One-Year/12-Month Constant Maturity Treasury (CMT)
This is an
index published by the Federal Reserve Board based on the average
yield of a range of Treasury securities, all adjusted to the
equivalent of a one-year maturity. The US Treasury determines the
yields on these securities by using the "daily yield curve". The
daily yield curve is based on the closing market-bid yields on
actively traded Treasury securities in the over-the-counter market.
This index tends to be volatile and responds quickly to changes in
economic conditions.
Summary:
This was the
index of choice for years for banks and many ARMs still on the books
are tied to this index. Because of its propensity to move quickly,
the 1-year T-bill index has become less attractive for many mortgage
originators and consumers as other alternative indexes have been
introduced. Normally the CMT has a two percent interest rate change
cap per year and a six percent lifetime cap, and the CMT has moved
two percent in a year several times over the past twenty-five
years.
Ideally
Suited for:
This index is ideally suited for a very limited market at
this time due to its volatility. It could possibly be used during a
downtrend in interest rates such as during an easing cycle by
the Fed - as it will tend to fall more quickly than other
indexes.
COSI
Cost of Savings
Index (COSI)
A bank receives
money from consumers in the form of deposits, and then lends money
as home mortgages or other loans. The interest rates in effect on
these deposits are the basis for the COSI index. It is not based on
actual interest paid, but rather the weighted annualized average of
all interest rates in effect on deposit accounts on the last day of
each month.
CODI
Certificates of
Deposit Index (CODI)
Similar to the
Cost of Savings Index above, this index is based on an average of
the 12 most recent monthly yields on 3-month certificates of deposit
(CDs).
Summary:
Both the CODI
and the COSI index are specific to one lending institution, World
Savings, and both average higher than the more universally used
index, the MTA. The biggest challenge associated with these indexes
is that the institution controls the margin on top of the loan, and
this margin is normally higher than most other ARM margins by
comparison. The product and indexes are good for niche product usage
for somewhat easier qualification for a customer with unique needs
such as NIV type loans or mildly credit challenged files.
Ideally
Suited for:
These indexes
are ideally suited for a slightly to more difficult type loan file
with credit, income or even reserve requirements being somewhat
below standard guidelines. In comparisons over time, these indexes
appear to be more expensive than more readily used ARM indexes
previously discussed. The good news is that presented properly, this
option can still be less expensive for your borrower than a
sub-prime type product, if they have borderline credit.
Prime
Wall Street
Journal (WSJ) Prime Rate
This is a
consensus measure of the Prime Rate, and is published in the Wall
Street Journal. The Wall Street Journal surveys the large banks and
then publishes their consensus "Prime Rate", or the rate offered to
clients who are considered eligible for "prime" financing terms. The
Prime Rate will move up or down in lock step with changes made by
the Federal Reserve Board. The Prime Rate is an important index used
by banks to set rates on many consumer loan products, such as credit
cards, auto loans, and certain Adjustable Rate Mortgages. When the
Prime Rate is rising, variable interest rate loans and credit card
rates will soon follow.
Summary:
This is a great
benchmark to use when comparing your selected ARM strategy to
another option. The majority of the ARM fully indexed rates will
normally be lower when compared to the Prime Rate and will make
sense to your business-minded clients.
This index is
not readily available for use as a long-term mortgage index for
consumer ARMs, but is primarily used for Home Equity Line of Credit
loans and other second mortgage products.
Federal Discount Rate
The Federal
Discount Rate is the interest rate charged by a Federal Reserve Bank
to its eligible member banks and financial institutions when they
need to borrow funds directly from the Federal Reserve. Banks whose
reserves fall below the reserve requirement set by the Federal
Reserve's Board of Governors use that money to correct their
shortage. The board of directors of each Reserve Bank sets the
Discount Rate every 14 days. Borrowing from the Federal Reserve is
generally considered a last resort option for banks, which usually
borrow from each other.
The Fed uses
the Discount Rate to control the supply of available funds, which in
turn influences inflation and overall interest rates. The more money
available, the more likely inflation will occur. Raising the
Discount Rate makes it more expensive to borrow from the Fed and
this lowers the supply of available money, which increases the
short-term interest rates. Lowering the Discount Rate has the
opposite effect, bringing short-term interest rates down.
Fed Funds Rate
The Fed Funds
Rate is the interest rate that Banks and other depository
institutions charge each other when they lend money to each other,
usually on an overnight basis. Federal law requires banks to keep a
certain percentage of their customer's money on "reserve" or right
at hand, where the banks earn no interest on it. Consequently, banks
try to stay as close to the reserve limit as possible without going
under it, lending money back and forth to each other in order to
maintain the proper reserve level. Similar to the Federal Discount
Rate, the Federal Funds Rate is used to control the supply of
available money and hence, inflation and other interest rates.
Raising this rate makes it more expensive to borrow and lowers the
supply of available money, which increases short-term interest rates
and helps keep inflation in check. Lowering the rate has the
opposite effect, bringing short-term interest rates down.
Summary:
Knowing the
facts about the Fed Funds rate and Discount rate are important to
being a fiscally literate originator.
These indexes
are not available for lending on consumer ARMs, but influence what
the Prime Lending Rate will be.
Interest Only
Interest is
what a borrower pays a lender over and above the original amount of
the loan, as compensation for the use of the money over a specified
period of time. An interest only loan requires a payment that pays
the interest that has accrued on the loan for the current month, but
with no principal reduction required at all for some specified
amount of time, outlined in the Note signed at closing. Permanent
mortgage loans normally only allow interest only payments for lower
cash flow for a specific number of years. The most common is the
5-year interest only product, yet there are many other types
available in the marketplace.
Summary:
Interest only
products offer a wonderful way to lower monthly cash flow for a
consumer, but do carry some risk and must be evaluated to make sure
they fit for the particular borrower.
Ideally
Suited for:
Ideally suited
for the more experienced borrower who can use the lower cash flow to
maximize financial leverage by pursuing other financial
opportunities.
Negative Amortization
Amortization is
the repayment of a loan by making systematic payments over a set
time period which are applied to the combined balance of the
principal and interest for that loan amount. Therefore, negative
amortization occurs when the payment is less than the required
interest that has accrued on the loan for that month.
Summary:
Few lenders
offer negative amortization loans today. Those that do have annual
payment caps and lifetime interest rate caps for steady control on
required payments over time.
Ideally Suited
for:
Ideally suited for a client living in an appreciating real
estate market who needs a consistent, predictable payment for cash
flow purposes, yet has the potential of income rising in the
future.
Margins
On an
adjustable rate loan, the amount a lender adds to the index in order
to determine the mortgage interest rate at each adjustment period.
For example, if the index is at 5.0, and the margin is 1.5, the
fully indexed interest rate is 6.5%. The margin is normally fixed
for the life of the loan.
Fully Indexed Rate
The fully
indexed rate is the combination of the index we have chosen plus the
fixed margin the lender places on the loan. This is often different
than the initial rate offered, or the ³start rate². The fully
indexed rate will only fluctuate at the adjustment period of your
ARM, and may be subject to caps that determine how much they may
increase within a certain time period.
Call Mortgage Sources Corp today to
Speak with your
Certified Mortgage Planning Specialist
Mark
Bustamonte
at (866) 840-2240
markb@mtgplanning.com | 
