Index is the name applied to a number that a lender uses as the basis for determining the interest rate of an ARM. The prime rate is an index. It’s the rate the big banks charge their best customers, but it is so frequently used that people refer to it as the prime rate rather than using the actual number at any given point in time. For example, if your bank granted you a business loan at prime plus 2 percent, you’d know exactly what they were talking about. If the prime rate were 8 percent, the interest on your loan would be 10 percent.
A lender uses an index the same way, and the rate on its loans during any period is based on the value of the index at the start of the period. Importantly, the index must be one that is beyond the control of the lender. You don’t want to pay more just because the head of some loan committee decided to raise rates.
In spite of the hype from lenders, there is no single index that is best all of the time. A loan is a financial instrument. If you own stocks, you know that over a long period of time, sometimes it’s better to be more heavily invested in stocks and other times in bonds. There are even times when you should have more cash. If you own stock, once a year you get a proxy statement from the company. As part of its annual report to you, the Securities and Exchange Commission (SEC) requires the company to show you a graph of the five-year performance of its stock, the performance of the S&P 500, and the performance of other companies in the same industry.
As an investor, you can see at a glance how the stock has been performing relative to other companies in the same industry and relative to the rest of the market. That’s an extraordinarily useful tool for investors. Borrowers should have a similar tool for comparing ARMs, and I’m going to give you one.
This is the rate banks pay on jumbo certificates of deposits greater than $100,000. It is almost always higher than the rate you can get on a CD at your local bank because it is not insured by the FDIC. It is also usually higher than the yield on U.S. Treasury 6-month T-bills. This index changes weekly, and loans tied to it usually change every six months. Loans tied to this index are not widely available, but some banks like it because a large portion of their deposit base is from CDs like this. It is also offered by a few large mortgage bankers. Lenders often offer this loan with a low margin, such as 2.125 percent. That’s a terrific loan, if you can find it.
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