Definition:
In real estate, an index is a benchmark interest rate that lenders use to calculate the interest rate for adjustable-rate mortgages (ARMs). The index fluctuates with market conditions and directly impacts a borrower’s mortgage payments after the initial fixed period.
Example:
Sarah gets a 5/1 ARM with a starting fixed rate for five years. After that, her interest rate will adjust annually based on the one-year Treasury index plus a 2% margin. If the index rises, her mortgage payment may go up too.
Explanation:
An index is a key part of how adjustable-rate mortgages work. After the fixed-rate period ends (such as in a 5/1 or 7/1 ARM), the new interest rate is calculated by adding a margin (a set number by the lender) to the current value of a financial index. Common indexes include:
- SOFR (Secured Overnight Financing Rate)
- U.S. Treasury Bill Index
- LIBOR (being phased out and replaced by SOFR)
- Cost of Funds Index (COFI)
For example, if the index is 3% and the lender’s margin is 2.5%, the new interest rate becomes 5.5%.
Because the index changes over time with the economy, your mortgage payments may go up or down after the initial fixed period. Lenders are required to explain which index they use and how often your rate can adjust.
Why is Index Important in Real Estate Transactions?
Understanding the index is important because it affects how much a borrower might pay after the initial fixed term of an ARM loan. For buyers, knowing how the index works helps them assess future financial risk. For sellers, it's useful to know what kind of loans buyers are using and how rising rates might impact their ability to afford the home.