How adjustable
mortgage rates are set
By Michael D. Larson
• Bankrate.com
 It
may seem arcane, quirky or downright strange, but the rates that
banks in Europe are charging each other to borrow money sometimes
determines what adjustable-rate mortgage (ARM) holders in the United
States are paying each month.
Lenders adjust ARM rates according to the movement
of indexes such as the London Interbank Offered Rate (LIBOR), which
reflects the rate most major international banks charge each other
for large loans.
Other gauges
Besides the LIBOR, which is one of the least popular gauges
used to calculate new rates, the one-year Treasury bill and 11th
District Cost of Funds Index are widely followed standards. In fact,
more than half of all ARMs follow the one-year Treasury, according
to Robert Van Order, chief economist for Freddie Mac of McLean,
Va., the publicly chartered company which buys residential mortgages
from lenders to package and sell to investors as securities.
Customers with one-year Treasury ARMs stand
to benefit from their simplicity, because short-term Treasury bills
are easy to follow through the newspaper, Van Order says.
The 11th District index is the second-most
popular benchmark and has been used since savings and loans in California
began searching for a new way to adjust rates. The index tracks
what the average deposit rate costs banks, allowing them to adjust
the rates they charge to borrowers in order to maintain a reasonable
spread.
Indexes affect rates
The 11th District refers to the western region of the
Federal Home Loan Bank System, a government-sponsored organization
that supports residential lending by banks and credit unions. The
index is largely popular in California, which makes up the majority
of the district, but it is used as a benchmark in other western
states as well, Van Order says. ARMs pegged to it adjust more slowly
than those tied to one-year Treasury, which helps to lessen volatility
and risk, but typically increases their cost to consumers.
With LIBOR-based products, borrowers can expect
to be protected against wide swings in rates. They typically will
enjoy caps on how much their rates can change during each semiannual
adjustment period, as well as over the life of the loan..
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