Many of us appreciate the flexibility and value of of adjustable rate mortgages (ARM) compared to ordinary fixed rate mortgages. When we all know the difference between a 5/1 ARM and a 3/1 ARM, we usually don't pay much attention to the index on which the future interest rate adjustment will be based on.
Bankrate's Dr. Don column presented an excellent summary on the major indices used in ARMs:
COFI - Cost of Funds Index (tends to lag the market)
COSI - Cost of Savings Index (based on saving rates; very stable)
MTA - 12-Month Treasury Average (based on last 12 months' interest trends; more stable than indices based on current spot rate only)
PRIME - Prime Rate (moves in lockstep with the Fed rate changes)
LIBOR - London Interbank Offer Rate (affected by both Fed rate and Bank of England's official rate)
I have to admit that the index of an ARM package never drove my decisions in financing decisions. However, I do know that my current ARM loan is LIBOR-based. When my current 5/1 ARM passes the initial fixed rate period, new rates will be decided by using one-year LIBOR rate plus a 2.25% margin.
At the time of getting my refinancing done, the one-year LIBOR rate is at 1.34%, which allows me to get this 3.5% 5/1 ARM (after some rounding and lender discounting). Today, the one-year LIBOR rate is at 2.30%, almost a full percentage point higher than five months ago. It is therefore no surprise that the prevailing ARM deals are priced at rates much higher than what I got.
If you just settled down with an ARM loan, you probably don't need to worry about the index rate change for a while, but if you are approaching the end of the initial fixed-rate window, you might want to act proactively to know your exposure of higher mortgage payments and make financial plans accordingly.