Adjustable-rate mortgages (ARM) are a type of mortgage in which the interest rate paid on the outstanding balance varies, according to a specific benchmark. Many benchmark indexes have been used to set interest rates for ARMS, including some proprietary benchmarks set by individual lenders. Understanding just a few of the more popular benchmarks and how they affect payments provides an overview of how benchmarks work and insight into their impact on mortgage payments. (To learn more, see The Best Definition Of A Benchmark Portfolio Is ...)

Meet the Benchmarks
Three common ARM benchmark indexes include the 11th District Cost of Funds Index (COFI), the One-Year Constant Maturity Treasury (CMT) and the London Interbank Offered Rate (LIBOR).

  • COFI is a benchmark based on a weighted average of the interest rates member banks of the Federal Home Loan Bank of San Francisco (the 11th district) pay to customers that have money in savings and checking accounts. The rate adjusts monthly. Mortgage loans that are linked to COFI change once per year. Since rates could rise every month for a year, but COFI only adjusts once, loans linked to COFI could have negative amortization, meaning that monthly payments aren't enough to cover the interest on the loan.

  • CMT is a benchmark based on the average one year-yield of the four most recently auctioned Treasury bills. Since the rate is based on the average over a 12-month period, a massive spike in rate of the one-year Treasury bill in a given month would only be factored into a borrower's mortgage rate on a 1/12 basis, as 11 other months would be part of the calculation used to set the interest rate.

  • LIBOR is a benchmark based on the interest rate banks in London pay when they borrow from each other. It is the world's most widely used benchmark for short-term interest rates. LIBOR-based mortgages are commonly based on the one-month LIBOR rate. (For more, check out our Introduction To LIBOR.)

There are more than a dozen other benchmarks that have been used to set mortgage rates. The specific details and names of the various benchmarks are not particularly important, but understanding the basic mechanics of these benchmarks is critical.

Mechanics: How Benchmarks Work
COFI and CMT are both based on averages. These rates tend to change slowly, which is good for borrowers when rates are rising but is less advantageous when rates are falling. LIBOR is not based on averages; it can rise rapidly, causing an equally rapid rise in borrowers' monthly mortgage payment.

While the rate borrowers pay is linked to the underlying benchmark, it does not match the benchmark. Lenders add an amount known as the margin, which is the portion of the interest rate on an adjustable-rate mortgage that is retained as profit by the lender.

Why Benchmarks Matter
Borrowers get to choose the institution from which they request a loan when they apply for a mortgage. When shopping for ARMs, this gives borrowers the ability to intentionally select or avoid a loan based on its benchmark index.

With this in mind, it is important to know the details of the loan you are seeking. Some of the questions that it is important to ask include: Is the benchmark based on averages? How often does it adjust? How much can it adjust? Is negative amortization possible? How much can my payment change? How often can it change?

Failure to ask these questions can lead to significant problems, as we saw in the aftermath of the housing bubble that burst in the late 2000s. Prior to the bubble bursting, ARMs made up more 20% of the mortgage market, according to the Mortgage Bankers Association. After the bubble burst, loan defaults reached double-digit numbers. Adjustments on ARMs accounted for significant portion of those defaults, and the number of borrowers interested in ARMs declined significantly. From their record-high level, ARMs lost 75% of their market share, falling to approximately 5% of the mortgage market. (To learn more, see Why Housing Market Bubbles Pop.)

In the wake of the housing bubble, lenders became significantly more conservative, and many of the proprietary ARM benchmarks faded away in favor of broader benchmarks such as CMT and LIBOR. Even with these changes, borrowers still have a variety of ARMs from which to choose.

Is an ARM Right for You?
Adjustable-rate mortgages can help borrowers save money if the economic environment is one in which interest rates are expected to fall. ARMs are also a useful tool for borrowers who expect to pay off their loans quickly. (For more, see ARMed And Dangerous.)

ARMs should not be used by borrowers who are relying on the lower interest rate in order to afford the mortgage payment. This is recipe for disaster, as rising interest rates can force the borrower into default. When in doubt, borrowers should stick with a fixed-rate mortgage. (Mortgages: Fixed-Rate Versus Adjustable-Rate provides insight into the advantages and disadvantages of both types of mortgages.)

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