What it means
Fixed-rate mortgages keep the same rate for years, whereas adjustable-rate mortgages reset at set intervals. At each reset the lender looks at the index, which is an independent market rate, and adds its margin.
Because the index is public and set by the market, borrowers can see why their rate changed. The margin is the lender's fixed add-on and is agreed when the loan is taken out.
It does not change for the life of the loan, so the same index can give different rates at different lenders. The formula for the rate is simply the index plus the margin.
Common indices are based on market rates, such as government bond yields or overnight lending rates between banks. Older loans may refer to indices that have since been retired or replaced, in which case the loan documents say which substitute applies.
Always read the loan agreement to see which index is used. Rate caps limit how much the rate can change.
A periodic cap restricts the change at each reset, and a lifetime cap limits the total rise over the loan's life. These caps protect borrowers, although a rate can still climb meaningfully inside them.
For households and companies with floating-rate debt, understanding the index lets you forecast payments. If the index is expected to rise, budgets should allow for higher costs, and some borrowers choose a fixed rate to remove that uncertainty.
One further point is the gap between the index and what the media call the mortgage rate. Headlines about mortgage rates usually refer to new fixed-rate loans, which follow the lender's view of future rates, whereas an adjustable-rate index reflects current short-term market rates.
The two can move differently, which surprises many borrowers.
In practice
Real-world examples.
Example
A homeowner with an adjustable-rate loan receives a letter before the reset date. It shows the index value, the margin and the new rate. She checks the index on a public website and sees that the figure matches. She then recalculates her new payment and puts it in her budget.
Example
A small business with a floating-rate mortgage on its warehouse watches the index closely. The finance manager expects it to rise, so she budgets an extra $2,000 a month for interest. She also asks the lender about fixing the rate.
Example
A first-time buyer compares two adjustable-rate offers using the same index. One has a margin of 2.25% and the other 2.75%. Since the index is the same, he can see that the first offer is cheaper by half a percentage point. On a $250,000 loan that difference is about $1,250 a year.
Formula
Calculation
Mortgage Rate = Index + Margin
Suppose an adjustable-rate mortgage uses an index currently at 4.00% and the lender's margin is 2.50%. The rate = 4.00% + 2.50% = 6.50%. On a $300,000 loan, annual interest is about 300,000 x 0.065 = $19,500. If the index rises to 5.00% at the next reset, the rate becomes 5.00% + 2.50% = 7.50%, and annual interest is 300,000 x 0.075 = $22,500, which is $3,000 more.Case study
Seen in the real world.
Greystone Logistics is an illustrative, fictional company that financed a depot with a $2,000,000 adjustable-rate mortgage tied to an index plus a 2.00% margin. The index started at 3.00%, giving a rate of 5.00%.
Two years later the index had climbed to 5.50%, lifting the rate to 7.50%. Annual interest rose from 2,000,000 x 0.05 = $100,000 to 2,000,000 x 0.075 = $150,000, an increase of $50,000.
The finance director had planned for this by building a reserve and agreed to fix the rate on half of the loan. The illustrative lesson is that the index is outside the borrower's control, so planning for movement is more useful than hoping it stays put. The company also now reviews the index every month when it prepares its cash flow forecast.
Watch out
Common mistakes.
- Thinking the lender sets the index, when it is a market benchmark and the lender only controls the margin.
- Comparing loans by the starting rate alone and ignoring the margin and caps.
- Assuming the rate cannot rise beyond the first adjustment, when it can keep changing at each reset until it reaches the lifetime cap written into the loan agreement.
Questions
People also ask.
What is the difference between the index and the margin?
The index is the moving market benchmark, and the margin is a fixed number of percentage points the lender adds.
Can the index fall?
Yes, if market rates fall, the index drops and your rate and payment may fall at the next reset.
Where do I find the index for my loan?
It is stated in your loan agreement, and the current value is normally published on financial news sites or by the organisation that compiles it, so you can check your lender's calculation yourself.
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