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Definition: Mortgage Index
Mortgage Index is the benchmark which is used to calculate the interest rate for an adjustable rate mortgage (ARM). The ARM interest rate comprises of the index interest rate and the margin. The margin remains constant but the interest rate associated with the index varies with the period of loan.
To understand mortgage index it is necessary to understand the concept of Adjustable Rate Mortgage (ARM). An adjustable rate mortgage is a type of loan in which interest rate on the loan remains fixed for a certain period of time and then varies as per a benchmark. A mortgage loan is taken by using a collateral like real estate. The loan provider can place a lien against the owner if the loan is not repaid and the property can be foreclosed.
An ARM has a fixed interest rate for a specified period and then the interest rate is revised monthly. For example a 5/25 ARM will have a fixed interest rate for 5 years and then the interest rate will vary for the remaining 25 years of the mortgage. In an ARM the party that takes the loan pays back the interest and also a margin called ARM margin.
During the initial years the
Interest rate = fixed interest rate
When the interest rate floats
Interest rate = Index + Margin.
The index interest rate changes as per the market conditions.
A few indexes that are used to calculate the varying interest rate are:
a. One year LIBOR (London Inter Bank Offer Rate)
b. Constant Maturity Treasury
c. 12 Month Treasury Average (MAT)
The lender decides the index and the margin on the loan. No index is better than the other, there are advantages and disadvantages with each index.