THE BASIS POINT

How Are Mortgage Rates Derived (Part 2)?

 

Last month we talked about how mortgage rates are derived. The question we got most was: If long-term, fixed rate mortgages are tied to mortgage bonds rather than the Fed Funds rate, then what is my adjustable rate mortgage (ARM) tied to? And what is my Home Equity Line of Credit 2nd mortgage tied to? The short answer is that ARM start rates are tied to mortgage bonds then get tied to indices that are correlated to Fed Funds when they adjust. HELOCs are tied to the Prime Rate, which is Fed Funds Rate + 3%. The longer answers are below.

What Will Happen To Rates on ARMs?
An ARM is fixed for a certain period, and this rate is priced based on mortgage bond yield levels. When it starts adjusting, the new rate will be derived by some market index plus a fixed margin. Let’s say you got into a 5.5% 3/6 LIBOR ARM in August 2001. So that 5.5% rate will start adjusting this August. It will adjust to the current market rate of the 6-month LIBOR index plus a set margin based on your credit score, your equity in your property, and other factors. If you made a 10% down payment on your home and have good credit, your margin might be 2%. And at press time, the 6-month LIBOR is at 1.57%. So your loan would adjust down to 3.57%. Then every 6 months, it would adjust again to the margin of 2% plus current LIBOR. The LIBOR is a rate the most creditworthy international banks charge when making loans to each other. It changes daily, so it tracks closely to the short term Fed Funds Rate. So as the Fed hikes rates to quell inflationary threats, your ARM may go up too, depending on the index it’s tied to. Some ARMs are tied to long-term Treasury indices which aren’t as sensitive to short-term Fed rates, but margins on those loans are usually higher.

What Will Happen To Rates On HELOCs
Home Equity Lines of Credit, a popular type of second mortgage, are also based on an index plus a fixed margin. The margin is set on the same parameters noted above. The index is almost always the Prime rate, a rate that U.S. banks give to their most creditworthy commercial borrowers. It adjusts monthly, and it is calculated by adding 3% to the Fed Funds Rate. Right now, Prime is at 4%, and a margin for a good credit risk borrower (as described above) is -.25% to 1%. So today, your rate might be 5% (Prime + a 1% margin). As the Fed continues to hike rates, Prime will follow suit. But even if it goes up 1% per year for the next 5 years, this type of loan–for now–is still a better deal than a fixed rate 2nd.

 

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