Today's LIBOR Rates
1 M |
0.31563 |
 |
3 M |
0.47500 |
|
6 M |
0.68794 |
|
1 YR |
1.06438 |
|
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The Index Fingered
A Comparison of Indices Used for Adjustable Rate Mortgages
January 24, 2009
People wonder what puts the “adjustable” in an adjustable rate mortgage, or ARM. Banks and mortgage companies don’t arbitrarily decide the interest rates to charge borrowers (regardless of impressions to the contrary). An index, a foundation rate generated and accepted by financial institutions, guides the number. The following are three notable indices for adjustable rate mortgages, including (naturally) a LIBOR rate.
Prime Rate
Many countries have a so-called “prime rate,” the base interest rate that banks charge their best commercial customers, a basis for other types of borrowing. In the United States, the most common version of the prime rate is the “Wall Street Journal Prime Rate.” The Wall Street Journal surveys the largest banks in the country to compile their lending rates and determine the prime rate. In the past, the publication has defined the prime as “the base rate on corporate loans posted by at least 75% of the nation’s 30 largest banks.” In late 2008, the polling group shrank to 10 institutions. When seven of them change their key commercial rate, then the Wall Street Journal adjusts the prime rate accordingly.
The prime rate is closely aligned with, but not a substitute for, the Federal Funds Target Rate, the interest rate that the governors of the Federal Reserve designate as the desired charge for interbank loans at the Federal Reserve. Since the mid 1990s, the WSJ Prime Rate has typically been 3% above the Federal Funds Target Rate. In turn, numerous other loans, including certain ARMs, assign interest rates at a set margin above the Prime.
MTA
MTA stands for “Monthly Treasury Average,” a 12-month averaging of the monthly average yields of one-year constant maturity U.S. Treasury securities. Since it is a longer-term mean, the MTA is considered a more stable figure than Constant Maturity Treasury (CMT) index for 12-month securities, a compilation of weekly or monthly average yields that can reflect immediate market volatility. However, MTA does not move as slowly as the 11th District Cost of Funds Index (COFI), another ARM index that takes a weighted average of interest paid by district-member institutions on savings and checking accounts, advances from the Federal Home Loan Bank, and other funding sources.
A slow-moving index benefits borrowers when overall rates are increasing. This becomes a negative if rates are dropping and the index lags the shift. MTA strikes an approximate balance between the more sensitive CMT and the more gradual COFI.
1-Year LIBOR
1-Year LIBOR is a filtered average of the rate that designated banks are charging other banks for 12-month loans. It is the longest maturity interbank loan commonly measured and referenced within the LIBOR index. The British Bankers’ Association (BBA) compiles LIBOR based on rates reported by “contributor banks” selected from BBA membership.
Much like the MTA, the 1-year LIBOR presents rate stability due to its 12-month cycle. Lenders will identify the effective one-year LIBOR rate annually to borrowers and adjust mortgages accordingly. This offers greater predictability versus more volatile, shorter-term LIBOR rates such as 1-month LIBOR, 3-month LIBOR or 6-month LIBOR. By using the 1-year LIBOR as an ARM index, borrowers can often qualify for a larger mortgage amount.