In addition to the many decisions you have to make when you are choosing a home loan, such as whether to go fixed or floating rate, how much down payment to make and how many points to pay, lenders have further complicated matters by offering a wide range of choice of indexes for ARMs (adjustable rate mortgages).
When we speak of the “index”, we are talking about of the base financial instrument that the changing rates will be based upon. These indices could be such things as the T-Bill rate, the rate of Federal Funds, or rates based on LIBOR.
You must first understand that an ARM is a mortgage with an interest rate that goes up or down within a certain set period, and the movements are predicated upon the movements of the underlying index. For example, if you chose the CD rate as your index, when CD rates go up, your home loan rate will go up. Adjustable rate mortgages have adjustment caps, which says that the interest rate can only be adjusted at certain periods, even if the underlying interest rate goes up more frequently; this can be an advantage if you just readjusted and then rates move up. By the same token, if your adjustment is scheduled to take place immediately after the CD rate increased, you will have that rate for a while, even if the CD rate comes back down in the interim.
ARMs can be tied to any number underlying instruments, for example the 90 day U.S. Treasury Bill. The Fed Funds rate is the most used index for ARMs. LIBOR is the London Interbank Offered rate, which is the rate that commercial borrowers pay each other to borrow money.
The index is a personal choice, based on the individual loan, and how the borrower feels interest rates will be heading. If you prefer a rate that is responsive to the interest rate market, you should choose the CD rate as your benchmark. Adjustable rate mortgages that use T Bills will change more slowly. LIBOR is one of the quickest moving indices, so if you want to take advantage of rapidly falling interest rates, this is the one to use.
But in addition to these standards, new products are always been introduced on the market; an example would be the option ARM, that will let a borrower decide how much mortgage he is going to pay each month! Of course, there is a minimum, normally the amount of interest, so the lender can guarantee its return, and then the balance goes toward the loan. Be warned that minimum payment option can result in an increasing, rather than decreasing mortgage, a concept known as negative amortization.
With this dizzying choice in interest rate scenarios for your mortgage, the best idea is to meet with a mortgage expert who can explain all of them to you and advise you best on your needs.