What Is a Fully Indexed Interest Rate?
A fully indexed interest rate is a variable interest rate that is calculated by adding a margin to a specified index rate. Fully indexed interest rates can vary broadly based on the assigned margin.
Fully Indexed Interest Rate Explained
Fully indexed interest rates are used for variable rate credit products. The margin on a fully indexed interest rate product is determined by the underwriter and based on the borrower’s credit quality. Adjustable rate mortgages (ARMs) are one of the most common fully indexed interest rate products.
Indexed rates form the basis for fully indexed interest rate products. They can also be used as the primary rate for a variable rate interest product.
Generally, a standard indexed rate is often the lowest rate a bank will charge to its highest credit quality borrowers. It is also often the rate banks charge for lending to other banks. Popular indexes for indexed rates include: the prime rate, LIBOR, and various U.S. Treasury bill and note rates.
Lenders typically assign a margin to most variable rate products which is added to a specified index rate to serve as the fully indexed interest rate charged to borrowers on credit balances. In a variable fully indexed interest rate product the margin will typically remain the same throughout the life of the loan with the interest rate adjusted based on changes to the standard indexed rate.
Margin is determined in the underwriting process. Higher credit quality borrowers can generally expect to be assigned a smaller margin while lower credit quality borrowers will pay a higher margin.
For example, if the fully indexed interest rate on a personal loan is tied to the six-month LIBOR index with a margin of 3% then the rate would be 10% if the six-month LIBOR index were at 7%. If the six-month LIBOR index were to increase to 8% then the new fully indexed interest rate would be 11%.
Adjustable Rate Mortgages
Adjustable rate mortgages are one of the credit markets most popular variable rate products. An adjustable rate mortgage can be best when a borrower believes mortgage rates will fall. These mortgages begin with a fixed rate for a specified number of years and then follow with a variable rate that resets based on the loan terms.
Quotes for ARMs can vary with the first number representing the years charging a fixed rate. A 2/28 ARM would have a fixed rate for two years followed by an adjustable rate for 28 years. A 5/1 ARM could have a fixed rate for five years followed by an adjustable rate that resets every year.
During the variable rate timeframe, the loan will be based on an indexed rate plus a margin. An open variable rate will increase or decrease when a change occurs with the indexed rate. If a loan has specific terms for resetting the interest rate such as at the end of each year then the interest rate will be adjusted to the fully indexed rate at the time of the adjustment.