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When you get an ARM, two main factors determine the rate you pay: the index and the margin. The index is a rate set by market forces and the margin is an agreed-upon number of percentage points that is added to the index to determine your rate.

Indexes based on average rates include the 11th District Cost of Funds Index (COFI) and the 12-month Treasury average (MTA and the MAT for monthly average Treasury). Then you have LIBOR, for London Interbank Offered Rate and there is the constant maturity Treasury, or CMT, index, which comes from a short-term average. Other indexes are based on the prime rate and yields on certificates of deposit.

London Interbank Offered Rate (LIBOR) indexes: The LIBOR (pronounced LIE-bore) tracks the rates at which London banks pay to borrow one another's reserves. It fluctuates more rapidly than the COFI or 12 MAT. The LIBOR is sort of a rough equivalent of the federal funds rate in the United States, but it is set by the market, not a government entity.

There are various LIBOR maturities. The most common are one-month, six-month and 12-month. A one-month LIBOR will be based on the rate for a one-month loan between London banks, and a mortgage based on the one-month LIBOR would be adjusted every month. A six-month LIBOR would be based on the rate for a six-month loan between London banks, and the mortgage based on that rate would be adjusted every six months.

11th District Cost of Funds Index (COFI) index: Rates on COFI-indexed mortgages move up and down slowly. With most COFI-based loans, the rate is adjusted every month and the monthly payment is adjusted once a year. Some borrowers can end up owing more than they borrowed if their payments don't cover all the interest due, a phenomenon called "negative amortization."

COFI-based loans are indexed to the cost of funds for the 11th district of the Federal Home Loan Bank system. The 11th district consists of banks based in Arizona, California and Nevada. The cost of funds index is a weighted average of the interest that member banks pay on money they borrow, mostly on customers' checking and savings accounts.

Anyone who has had a savings, money market or interest-bearing savings account knows that those rates are low and move tortoise-like. The COFI (pronounced "coffee") is calculated at the end of every month for the previous month, and lags the overall market. The COFI's slow, lagging pace benefits borrowers when rates are rising.

12-month Treasury average (MTA or MAT) indexes
Monthly option ARM:
Rates on ARMS indexed to the 12-month average of the one-year Treasury bill are usually called the "12 MAT" or "12 MTA." Every month, the U.S. Treasury calculates and publishes the average yield on a constant-maturity 1-year Treasury bill for the previous month. The 12 MAT index takes the average of the last 12 averages.

Like the COFI, the rate on a 12 MAT is adjusted every month. Depending on the loan program, the monthly payment might be adjusted every month or once a year. Rates indexed to the last 12 monthly averages for 1-year Treasuries move slowly. The 12 MAT index reacts slowly to fluctuations in short-term rates and smoothes them out.

Constant-maturity Treasury (CMT) indexes: These indexes follow the weekly or monthly fluctuations in the yields for 1-year Treasury bills. The rates on CMT-indexed ARMs move up and down rather quickly. Most CMT-indexed mortgages are adjusted once a year.

CMT-indexed loans are among the most popular ARMs. Hybrid ARMs -- home loans that have a fixed rate for the first few years, then adjust annually -- usually turn into CMT-indexed mortgages when they enter their adjustment periods.

If you're paying attention, you might have noticed that CMT-indexed mortgages are based on a weekly or monthly average and adjust once a year, while MAT-indexed mortgages are based on an annual average and adjust every month.

Other features to look for include the ability of a home's future buyer to assume the mortgage, and the capability to modify the loan -- to switch to another index without having to go through an expensive refinance.


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