LIBOR
London Inter-Bank Offered Rate (LIBOR)

LIBOR is the rate of interest that member banks of the British Bankers' Association charge when they lend money to one another in the wholesale money markets in London, somewhat similar to our Fed Funds Rate. In fact, the LIBOR tends to closely track the US Fed Funds Rate. LIBOR is a standard financial index that is used globally and in US capital markets, and the Wall Street Journal publishes the index on a daily basis. In general, changes in the LIBOR have tended to be smaller than changes in the Prime Rate. There are several LIBOR maturities much like U.S. Treasuries, but the 1-month and 6 month are the most readily used and available LIBOR indexes for mortgage loans. Although they are becoming increasingly more common in use for consumer loans and ARM¹s, LIBOR Indices have traditionally been a reference figure for corporate and commercial financial transactions.

Summary:
Over the past several years, the LIBOR has slowly begun to replace the more commonly used 1-year T-bill index as the index of choice for hybrid ARMs such as 3-, 5-, 7-, and 10 yr products to determine rate at their adjustment periods. It is very established and dependable, yet it does carry a risk of slightly larger volatility when the US Dollar fluctuates. This is due to the fact that LIBOR is a European based index and reacts to the dollar strengthening or weakening much like the Euro becoming more valuable or less valuable to the dollar in slowing and expanding economic situations. The shorter term LIBOR products are great in a Fed easing cycle, but should be used cautiously and possibly avoided when the Fed is hiking short-term rates, as the index could rise very quickly. In these situations, a better option may be the 3 or 5 year Hybrid LIBOR ARMs.

Ideally Suited for:
This index is ideally suited for the more aggressive borrower on the 1 month and 6 month products as it will tend to fall faster than any other index and yet also rise as fast as the Fed hikes in rising markets and sometimes even faster depending on currency conditions. The key here is the margin. Some investors offer buy downs into the low 1% range for this product and can make it a very attractive choice when looking at a ten year chart with your customer. Hybrid ARMs such as the 3-, 5-, 7-, and 10-year products that use the LIBOR for the change rate at adjustment time can have a wide variety of use depending on your clients' desired length of time in their home and other specific needs and goals.

MTA

Monthly Treasury Average (1 year MTA)

This index is determined by averaging one-year Treasury bills each month over the prior 12 month time period. This is an index used to set the cost of various variable-rate loans, particularly adjustable-rate mortgages. The use of the 1-Year MTA as a loan index is relatively new. The MTA generally fluctuates more than the 11th District Cost-of-Funds Index (COFI  see below), although they both track each other closely.

Note:
The MTA index is often used in what are commonly referred to as "Option ARMs". This product type can create terrific cash flow and payment stability for your customer in the early years of the loan, but requires a great presentation from you and education on the consequences of the different payment options, such as negative amortization.

Summary:
The one year MTA is the most popular index for ARMs when looking for stability and low volatility. Very predictable in a one year or less outlook for your customer, and has a very clear track record of rising slower than other popular indexes with competitive margins.

Ideally Suited for:
This index is ideally suited for mid-level to even conservative borrowers that are short to mid term dwellers in their home. The MTA is great in a steady but rising interest rate environment when measuring against a fixed rate. As long as the spread between current fixed rates and the fully indexed rate on the MTA is a full one percent or greater, an ARM tied to this index can be a very good strategy.

COFI

Cost of Funds Index (COFI)

This is a monthly cost-of-funds index (COFI) reflecting the weighted-average interest rate paid by a particular Federal Home Loan Bank District savings institution on savings and checking accounts. The 11th District is the one most commonly used, which covers Arizona, California and Nevada. The COFI index is published on the last day of the month, and reflects the cost of funds for the prior month. COFI usually lags behind market interest rates in both up and down markets, which means that loans tied to this index rise and fall more slowly than interest rates in general.

Summary:
The COFI is a stable index that is still available but is not used as widely as it once was due to the massive consolidation in the S&L industry over the past decade. With fewer and fewer S&L’s the bottom line costs of the big ones that are left are lower and more stable, which does not bode well for an investor in an upward or volatile market. Since a consistently higher margin is tied to this product it will be less attractive for your customer.

Ideally Suited for:
This index is ideally suited for a niche borrower with some qualifying challenges who is comfortable with a slightly higher effective rate. Great for a stable to rising interest rate environment.

1 Year T-Bill

One-Year/12-Month Constant Maturity Treasury (CMT)

This is an index published by the Federal Reserve Board based on the average yield of a range of Treasury securities, all adjusted to the equivalent of a one-year maturity. The US Treasury determines the yields on these securities by using the "daily yield curve". The daily yield curve is based on the closing market-bid yields on actively traded Treasury securities in the over-the-counter market. This index tends to be volatile and responds quickly to changes in economic conditions.

Summary:
This was the index of choice for years for banks and many ARMs still on the books are tied to this index. Because of its propensity to move quickly, the 1-year T-bill index has become less attractive for many mortgage originators and consumers as other alternative indexes have been introduced. Normally the CMT has a two percent interest rate change cap per year and a six percent lifetime cap, and the CMT has moved two percent in a year several times over the past twenty-five years.

Ideally Suited for:
This index is ideally suited for a very limited market at this time due to its volatility. It could possibly be used during a downtrend in interest rates  such as during an easing cycle by the Fed - as it will tend to fall more quickly than other indexes.

COSI

Cost of Savings Index (COSI)

A bank receives money from consumers in the form of deposits, and then lends money as home mortgages or other loans. The interest rates in effect on these deposits are the basis for the COSI index. It is not based on actual interest paid, but rather the weighted annualized average of all interest rates in effect on deposit accounts on the last day of each month.

CODI

Certificates of Deposit Index (CODI)

Similar to the Cost of Savings Index above, this index is based on an average of the 12 most recent monthly yields on 3-month certificates of deposit (CDs).

Summary:
Both the CODI and the COSI index are specific to one lending institution, World Savings, and both average higher than the more universally used index, the MTA. The biggest challenge associated with these indexes is that the institution controls the margin on top of the loan, and this margin is normally higher than most other ARM margins by comparison. The product and indexes are good for niche product usage for somewhat easier qualification for a customer with unique needs such as NIV type loans or mildly credit challenged files.

Ideally Suited for:
These indexes are ideally suited for a slightly to more difficult type loan file with credit, income or even reserve requirements being somewhat below standard guidelines. In comparisons over time, these indexes appear to be more expensive than more readily used ARM indexes previously discussed. The good news is that presented properly, this option can still be less expensive for your borrower than a sub-prime type product, if they have borderline credit.

Prime
Wall Street Journal (WSJ) Prime Rate

This is a consensus measure of the Prime Rate, and is published in the Wall Street Journal. The Wall Street Journal surveys the large banks and then publishes their consensus "Prime Rate", or the rate offered to clients who are considered eligible for "prime" financing terms. The Prime Rate will move up or down in lock step with changes made by the Federal Reserve Board. The Prime Rate is an important index used by banks to set rates on many consumer loan products, such as credit cards, auto loans, and certain Adjustable Rate Mortgages. When the Prime Rate is rising, variable interest rate loans and credit card rates will soon follow.

Summary:
This is a great benchmark to use when comparing your selected ARM strategy to another option. The majority of the ARM fully indexed rates will normally be lower when compared to the Prime Rate and will make sense to your business-minded clients.

This index is not readily available for use as a long-term mortgage index for consumer ARMs, but is primarily used for Home Equity Line of Credit loans and other second mortgage products.

Federal Discount Rate
The Federal Discount Rate is the interest rate charged by a Federal Reserve Bank to its eligible member banks and financial institutions when they need to borrow funds directly from the Federal Reserve. Banks whose reserves fall below the reserve requirement set by the Federal Reserve's Board of Governors use that money to correct their shortage. The board of directors of each Reserve Bank sets the Discount Rate every 14 days. Borrowing from the Federal Reserve is generally considered a last resort option for banks, which usually borrow from each other.

The Fed uses the Discount Rate to control the supply of available funds, which in turn influences inflation and overall interest rates. The more money available, the more likely inflation will occur. Raising the Discount Rate makes it more expensive to borrow from the Fed and this lowers the supply of available money, which increases the short-term interest rates. Lowering the Discount Rate has the opposite effect, bringing short-term interest rates down.

Fed Funds Rate

The Fed Funds Rate is the interest rate that Banks and other depository institutions charge each other when they lend money to each other, usually on an overnight basis. Federal law requires banks to keep a certain percentage of their customer's money on "reserve" or right at hand, where the banks earn no interest on it. Consequently, banks try to stay as close to the reserve limit as possible without going under it, lending money back and forth to each other in order to maintain the proper reserve level. Similar to the Federal Discount Rate, the Federal Funds Rate is used to control the supply of available money and hence, inflation and other interest rates. Raising this rate makes it more expensive to borrow and lowers the supply of available money, which increases short-term interest rates and helps keep inflation in check. Lowering the rate has the opposite effect, bringing short-term interest rates down.

Summary:
Knowing the facts about the Fed Funds rate and Discount rate are important to being a fiscally literate originator.

These indexes are not available for lending on consumer ARMs, but influence what the Prime Lending Rate will be.

Interest Only

Interest is what a borrower pays a lender over and above the original amount of the loan, as compensation for the use of the money over a specified period of time. An interest only loan requires a payment that pays the interest that has accrued on the loan for the current month, but with no principal reduction required at all for some specified amount of time, outlined in the Note signed at closing. Permanent mortgage loans normally only allow interest only payments for lower cash flow for a specific number of years. The most common is the 5-year interest only product, yet there are many other types available in the marketplace.

Summary:
Interest only products offer a wonderful way to lower monthly cash flow for a consumer, but do carry some risk and must be evaluated to make sure they fit for the particular borrower.

Ideally Suited for:
Ideally suited for the more experienced borrower who can use the lower cash flow to maximize financial leverage by pursuing other financial opportunities.

Negative Amortization

Amortization is the repayment of a loan by making systematic payments over a set time period which are applied to the combined balance of the principal and interest for that loan amount. Therefore, negative amortization occurs when the payment is less than the required interest that has accrued on the loan for that month.

Summary:
Few lenders offer negative amortization loans today. Those that do have annual payment caps and lifetime interest rate caps for steady control on required payments over time.

Ideally Suited for:
Ideally suited for a client living in an appreciating real estate market who needs a consistent, predictable payment for cash flow purposes, yet has the potential of income rising in the future.Margins

On an adjustable rate loan, the amount a lender adds to the index in order to determine the mortgage interest rate at each adjustment period. For example, if the index is at 5.0, and the margin is 1.5, the fully indexed interest rate is 6.5%. The margin is normally fixed for the life of the loan.

Fully Indexed Rate
The fully indexed rate is the combination of the index we have chosen plus the fixed margin the lender places on the loan. This is often different than the initial rate offered, or the ³start rate². The fully indexed rate will only fluctuate at the adjustment period of your ARM, and may be subject to caps that determine how much they may increase within a certain time period.