Types of Indexes Used to Calculate the Interest Rate on ARMs

Adjustable-rate mortgages (ARMs) have interest rates that change periodically, unlike fixed-rate mortgages. These adjustments are based on financial indexes that track market interest rates, directly affecting borrowers’ monthly payments. Understanding these indexes is essential for anyone considering an ARM.

Treasury-Based Indexes

Some ARMs adjust based on U.S. Treasury securities, which are backed by the federal government and considered relatively stable. These indexes are derived from Treasury yields with different maturities and are published by the U.S. Department of the Treasury.

1-Year CMT

The 1-Year Constant Maturity Treasury (CMT) index is based on the yield of a one-year Treasury security, adjusted daily to reflect market conditions. Treasury yields fluctuate with economic indicators, inflation expectations, and Federal Reserve policy, making this index sensitive to short-term rate movements. Borrowers with ARMs tied to this index may see frequent payment adjustments, especially during economic volatility.

Lenders add a margin to the CMT index rate to determine the fully indexed interest rate, so borrowers should pay attention to both the index value and the margin in their loan agreements.

3-Year CMT

The 3-Year CMT follows the same methodology as the 1-Year CMT but is based on three-year Treasury yields. Because it reflects a longer maturity, it is less volatile, providing more stability for borrowers. It moves in response to broader economic trends, such as long-term inflation expectations and Federal Reserve policies.

ARMs tied to the 3-Year CMT typically adjust less frequently, offering more predictable payments. However, because it responds to both short- and long-term factors, it may not always move in sync with short-term market rates. During periods of rising interest rates, it may adjust more slowly than shorter-term indexes but can still increase over time.

5-Year CMT

The 5-Year CMT is based on five-year Treasury yields and is adjusted to maintain a constant maturity. It is more stable than the 1-Year and 3-Year CMT indexes since five-year yields are influenced by long-term economic trends rather than short-term fluctuations.

ARMs tied to this index often have longer initial fixed-rate periods, such as 5/1 ARMs, where the rate remains unchanged for the first five years before adjusting periodically. While the stability of the 5-Year CMT can be beneficial in a rising rate environment, rates based on longer-term indexes may start higher than those tied to shorter-term benchmarks. Borrowers should consider how this index interacts with broader economic conditions when evaluating mortgage options.

Prime Rate Index

The prime rate is a benchmark banks use to set interest rates on various loans, including some ARMs. It is determined by individual banks but is heavily influenced by the federal funds rate set by the Federal Reserve. When the Fed raises or lowers interest rates, the prime rate typically moves in the same direction.

Lenders use the prime rate as a reference point for pricing loans, adding a margin to determine the final rate borrowers pay. Because it is based on rates banks charge their most creditworthy customers, it tends to be higher than Treasury-based indexes. This means ARMs tied to the prime rate can experience more significant fluctuations, especially during aggressive Fed policy changes.

Since the prime rate responds to inflation, employment data, and overall market confidence, it can rise during economic expansions and fall during recessions. This responsiveness can benefit borrowers when rates decline, but payments can increase quickly when conditions shift.

COFI Index

The Cost of Funds Index (COFI) is based on the interest expenses incurred by financial institutions, particularly savings banks and credit unions. Unlike market-driven benchmarks that react immediately to economic shifts, COFI reflects actual borrowing costs for these institutions, resulting in a lagging effect where changes in broader interest rates take longer to influence COFI-based mortgage rates.

COFI is compiled from the funding costs of banks in specific regions, particularly the 11th Federal Home Loan Bank District, making it sensitive to local economic conditions. If banks in this district face higher deposit costs due to increased competition for savings accounts, COFI may rise even if national interest rates remain stable.

Borrowers with ARMs linked to COFI often experience more stable payments compared to those tied to short-term lending rates. Since financial institutions adjust their funding strategies incrementally, COFI does not exhibit the same level of volatility as indexes that track daily or monthly rate fluctuations. This can be beneficial when rates are rising sharply, as payments may increase at a slower pace. However, during periods of declining rates, COFI-based loans may not decrease as quickly as those tied to more reactive benchmarks.

MTA Index

The 12-Month Treasury Average (MTA) index is calculated using the average of one-year U.S. Treasury yields over the past twelve months. This averaging mechanism smooths out short-term market fluctuations, making it less volatile than indexes that respond immediately to interest rate changes.

Borrowers with ARMs tied to the MTA index often experience gradual rate adjustments rather than sudden spikes, providing more stability in monthly payments. However, because the MTA index reflects an extended period of historical data rather than current market conditions, it tends to lag behind other benchmarks that adjust more frequently.

This delayed response can be beneficial when interest rates are rising, as borrowers may enjoy lower rates for a longer period before adjustments take effect. However, in a declining rate environment, the same lag means it takes longer for borrowers to see reductions in their mortgage rates. This characteristic makes it appealing to those who prioritize predictability over rapid responsiveness to economic shifts.

SOFR Indexes

The Secured Overnight Financing Rate (SOFR) has become a widely used benchmark for ARMs, particularly after the phase-out of the London Interbank Offered Rate (LIBOR). Unlike LIBOR, which was based on estimated interbank lending rates, SOFR is derived from actual transactions in the U.S. Treasury repurchase agreement (repo) market, making it a more transparent and reliable indicator of short-term borrowing costs.

Simple

The simple SOFR index is calculated by taking the daily SOFR rate and applying it without compounding. This straightforward approach reflects the average cost of borrowing in the overnight repo market over a given period. Borrowers with ARMs tied to the simple SOFR index may see their rates adjust more frequently, as this method does not smooth out fluctuations over time.

While this can be beneficial in a declining rate environment, it also means borrowers are more exposed to short-term volatility. Lenders typically add a margin to the simple SOFR rate to determine the final interest rate, so understanding both components is important when evaluating loan terms.

Compounded

The compounded SOFR index takes daily SOFR rates and applies a compounding formula over a specified period, such as 30, 60, or 90 days. This method reduces the impact of daily fluctuations and provides a more stable benchmark for mortgage adjustments. Because compounding accounts for the reinvestment of interest, it tends to result in slightly higher rates compared to the simple SOFR method.

Borrowers with ARMs tied to compounded SOFR may experience smoother rate adjustments, which can help with budgeting and financial planning. However, the complexity of compounding calculations means borrowers should carefully review how their lender applies this index to understand how their payments may change over time.

Average Variations

SOFR can also be applied using different averaging methods, such as a 30-day, 90-day, or 180-day rolling average. These variations help mitigate the impact of short-term rate spikes by spreading adjustments over a longer period. A 30-day average SOFR index reflects borrowing costs over the past month, making it more responsive to recent market conditions. In contrast, a 180-day average smooths out fluctuations over a longer timeframe, providing greater stability.

Borrowers should consider how frequently their ARM adjusts and whether a shorter or longer averaging period aligns better with their financial goals. Since different lenders may use different SOFR averaging methods, comparing loan terms carefully can help borrowers make informed decisions.