The borrower’s credit score usually determines the size of the margin. Most loans have caps on how high variable interest rates can rise or fall over a given period of time.
Definition and Example of a Fully Indexed Interest Rate
A fully indexed interest rate is a variable rate set at a fixed rate above a reference rate. The typical reference rates used are the secured overnight financing rate (SOFR), the federal funds rate, or the one-year Treasury rate. Fully indexed interest rates can vary considerably depending on the benchmark used or the size of the margin. If you take out an adjustable-rate mortgage (ARM), you’ll receive a fully indexed interest rate. With an ARM, you’ll receive a discounted index rate for the first year or so, called the teaser rate. After a year or two, your ARM will adjust every five years or so. Once the rate changes, your ongoing fully indexed interest rate will depend on market conditions.
How a Fully Indexed Interest Rate Works
If you apply for a variable-rate loan, the rate is determined by two factors: an index and a margin. The index is a publicly available rate that the lender doesn’t control. However, your lender will decide which benchmark your index is based on. The index will change over time, depending on market conditions, causing your variable interest rate to rise or fall. In comparison, the margin is the number of percentage points added to the index by your mortgage lender. The margin is based on your credit score, and this rate is locked in after you close on the loan. So to determine your fully indexed interest rate, you’ll add the margin to the index.
Types of ARMs
If you’re considering applying for an ARM, let’s look at three types you can consider.
1. Hybrid ARM
A hybrid ARM is a combination of a fixed-rate and adjustable-rate mortgage. You’ll have a fixed rate for a period of time, followed by an adjustable rate. A hybrid ARM comes with two numbers, and the first determines the length of the fixed-rate interest period. The second number specifies how often the interest rate will adjust after the introductory period is up. For example, if you take out a 5/1 ARM, you’ll have a fixed rate for the first five years of the loan. After that, the interest rate will adjust annually until the mortgage is paid off.
2. Interest-Only ARM
An interest-only ARM allows you to make only interest payments for a set period of time. This introductory period usually lasts three to ten years. That means your monthly payments will be smaller until the intro period is up. After the initial term is over, your payments will be higher because you’ll start making payments on interest and principal.
3. Payment-Option ARM
A payment-option ARM lets you choose between several different payment options. For instance, you can make traditional interest and principal payments. That means your monthly payments will be higher, but you’ll pay off your mortgage faster.
You can also choose interest-only payments. With this option, your monthly payments will be lower in the beginning, but it will take you longer to repay the loan. Finally, you can choose a minimum payment where you pay less interest each month. Paying less interest will reduce your monthly payments, but any interest you don’t pay is added on to the principal of the loan. So this option will increase your overall principal and will eventually lead to higher mortgage payments, sometimes called balloon payments, later on.
