"Interest Rates and Indexes Explained: MTA, COFI, Prime Rate, & LIBOR"

Federal funds rate

The federal funds rate is the interest rate at which depository institutions lend balances (federal funds) at the Federal Reserve to other depository institutions overnight.

Here is how the system works:

U.S. banks and thrift institutions are obliged by law to keep certain no-interest-bearing reserves with the Fed (or to keep an equal amount of vault cash, but this imposes risks and costs). The level of these reserves is determined by the outstanding assets and liabilities of each depository institution, as well as by the Fed itself, but is typically 10% of the total value of the bank's demand accounts.
Assume that a particular U.S. depositary institution (Bank A) needs additional money in order to keep its reserve at the Fed at the legally required level. To this purpose, it will borrow the requisite funds from another bank (Bank B) that has a surplus in its Fed reserves. The interest rate that Bank A will pay to Bank B in return for borrowing the funds is negotiated between the two banks, and the weighted average of this rate across all banks is the effective Federal Funds Rate.
The nominal rate is a target set by the governors of the Federal Reserve, which they enforce primarily by open market operations (the buying and selling of bonds). When the media refer to the Federal Reserve "changing interest rates," this nominal rate is almost always meant. The target is generally a range, as the Federal Reserve cannot set an exact value through open market operations.

Another way banks can borrow funds to keep up their required reserves is by getting a loan from the Federal Reserve itself at the discount rate. These loans are very short term and rare, as they are subject to audit by the Fed, which is why overnight loans between institutions are preferred. Confusion between these two kinds of loans often leads to confusion between the federal funds rate and the discount rate, the rate at which the Fed lends to financial institutions. Another difference is that, while the Fed cannot set an exact federal funds rate, it can set a specific discount rate.

Prime rate

The Prime Rate is used often in calculating mortgages and other variable rate loans. It is used in the calculation of some private student loans. Many credit cards with variable interest rates have their rate specified as the prime rate plus a fixed value.

In general, the prime rate runs above the Federal Funds Rate, the interest rate that banks charge to each other for overnight loans made to fulfill reserve funding requirements. (The Federal funds rate plus a much smaller increment is frequently used for lending to the most creditworthy borrowers today, as is LIBOR, the London Interbank Offered Rate.) The Federal Open Market Committee (FOMC) meets eight times per year wherein they set a target for the federal funds rate. Other rates, including the Prime Rate, derive from this base rate.

The most commonly recognized prime rate index is the Wall Street Journal Prime Rate (WSJ Prime Rate), published in the Wall Street Journal. Unlike other indexed rates, the prime rate does not change on a regular basis; rather, it changes whenever banks need to alter the rates at which borrowers obtain funds. The WSJ defines the prime rate as "The base rate on corporate loans posted by at least 75% of the nation's 30 largest banks." It has been speculated though that this is no longer the real definition, (and that the prime rate is simply the fed funds target rate + 3) because most corporate loans are indexed to LIBOR.

When 23 out of 30 of the United States' largest banks change their prime rate, the WSJ prints a composite prime rate change.

History of Prime Rate visit http://mortgage-x.com/general/indexes/prime_rate.asp

11th District Cost of Funds Indices

The 11th District Monthly Weighted Average Cost of Funds Index (COFI) is one of many indices used by mortgage lenders to adjust the interest rate on adjustable rate mortgages. The COFI is computed from the actual interest expenses reported for a given month by the Arizona, California, and Nevada savings institution members of the Federal Home Loan Bank of San Francisco (Bank) that satisfy the Bank's criteria for inclusion in the COFI (COFI Reporting Members).
 
In addition to the COFI, the Bank publishes semi-annual weighted average cost of funds indices for Arizona, California, and the 11th District. Since the largest part of the Cost Of Funds index is interest paid on savings accounts, this index lags market interest rates in both uptrend and downtrend movements. As a result, ARMs tied to this index rise (and fall) more slowly than rates in general, which is good for you if rates are rising but not good for you if rates are falling. ARMs based on this index can adjust every month, every six months, or every year.

Many COFI-indexed ARMs often have payment caps, but no periodic interest rate caps creating the possibility for negative amortization (your loan balance can increase).

History of COFI Index visit: http://mortgage-x.com/general/indexes/cofi.asp

Payment Caps

Some types of ARMs (for example, option ARM loans) offer payment caps rather than interest rate caps, which limit the amount the monthly payment can increase. If a loan has payment cap but has no periodic interest rate cap, then the loan may become negatively amortized: if the interest rates rise to the point that the monthly mortgage payment does not cover the interest due, any unpaid interest will get added to the loan balance, so the loan balance increases. However, you always have the option to pay the minimum monthly payment, or the fully amortized amount due. With most COFI-based loans, the rate is adjusted every month and the monthly payment is adjusted once a year. This means that some borrowers can end up owing more than they borrowed if their payments don't cover all the interest due, a phenomenon called "negative amortization."

Example:

Your loan has a payment cap of 7.5%. If your payment is $1,000 per month and interest rates rise, your new payment would normally be $1,275/month (for example). But your capped payment is only $1,075. The other $200 get added to your loan balance, to be paid off over time, unless  you decide to pay that additional amount now.

Periodic Interest Rate Caps

A limit on how much the interest rate or the monthly payment can change, either at each adjustment or during the life of the mortgage. Most ARMs have an interest rate caps to protect you from huge increases in monthly payments. A lifetime cap limits the interest rate increase over the life of the loan. Lifetime caps can vary by lender, but most ARMs have caps of 5% or 6%. A periodic or adjustment cap limits how much your interest rate can rise at one time. Generally, a 6 month ARM will have a cap of 1% while a 1 year ARM will have a 2% cap. A rate that adjusts every month has no periodic cap and may in fact reaches the lifetime cap any month.

Periodic and lifetime caps are quoted as two numbers as in 2/6, which would mean that periodic cap is 2% and the lifetime cap is 6%.

Examples:

1. The initial interest rate is 4.5%, the index is 7%, and the margin is 3%,
then the new interest rate = 7% + 3% = 10%.
If the lifetime cap is 5% then
the actual new interest rate will be 4.5% + 5% = 9.5%.

2. The initial interest rate is 6%, the index is 5%, and the margin is 3%,
then the new interest rate = 5% + 3% = 8%.
If the periodic cap is 1% then
the actual new interest rate will be 6% + 1% = 7%.

Some ARMs are quoted as three numbers as in 5/2/5 which means that the first adjustment cap is 5%, adjustment cap thereafter is 2%, and the lifetime cap is 5%.

12-month Treasury average (MTA or MAT) indexes:

Rates on ARMS indexed to the 12-month average of the one-year Treasury bill are usually called the "12 MAT" or "12 MTA." Every month, the U.S. Treasury calculates and publishes the average yield on a constant-maturity 1-year Treasury bill for the previous month. The 12 MAT index takes the average of the last 12 averages.

Like the COFI, the rate on a 12 MAT is adjusted every month. Depending on the loan program, the monthly payment might be adjusted every month or once a year.

Rates indexed to the last 12 monthly averages for 1-year Treasuries move slowly. "If interest rates were to go up 100 basis points tomorrow, in other words, if they rose 1 percentage point, that index would go up only one-twelfth of 1 percent the next month. And then the second twelfth the next month, and so on.

The 12 MAT index reacts slowly to fluctuations in short-term rates and smoothes them out.

History of MTA Index visit http://mortgage-x.com/general/indexes/mta.asp

London Interbank Offered Rate (LIBOR) indexes:

The LIBOR (pronounced LIE-bore) tracks the rates at which London banks pay to borrow one another's reserves. It fluctuates more rapidly than the COFI or 12 MAT. The LIBOR is sort of a rough equivalent of the federal funds rate in the United States, but it is set by the market, not a government entity.

London Interbank Offered Rate (or LIBOR) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). This is the interest rate that London banks charge when lending to one another in order to manage their balance sheets. The LIBOR is the equivalent of the American Federal Funds Rate and is used as a benchmark for other short term interest rates.

LIBOR-indexed ARMs offer borrowers aggressive initial rates (lower than many other ARMs) and has proved to be competitive with such popular ARM indexes as the 11th District Cost of Funds, the 6-Month Treasury Bill, and the 6-Month Certificate of Deposit. With the LIBOR ARMs borrowers are generally protected from wide fluctuations in interest rates by periodic and lifetime interest rate caps. LIBOR ARMs usually do not have negative amortization.

History of LIBOR Index visit http://mortgage-x.com/general/indexes/libor.asp

Treasury Bill (T-Bill) Indexes

These indexes are based on the results of auctions that the U.S. Treasury holds for its Treasury bills, notes and bonds.

Treasury bills are issued by the U.S. government with maturities of 1, 3 and 6 months (4-week, 13-week, 26-week bills or 28-day, 91-day, 182-day bills) in order to pay for the national debt and other expenses. The 3- and 6-month Treasury bills are auctioned every Monday and the resulting figures are released to the public the next day. Treasury bill auction results provide the discount rate*, investment yield, and price for recently auctioned bills.

http://www.federalreserve.gov/releases/h15/current/

History of Treasury Bill visit http://mortgage-x.com/general/indexes/t-bill.asp

To view current updates on current Indexes values visit http://mortgage-x.com/general/mortgage_indexes.asp

Andre Plessis

Andre Plessis
"The Mortgage Guru"
"Andre Plessis is a Mortgage Planner and Author. He helps individuals improve their credit and offer guidance in personal finance. His primary goal is to provide the expertise, guidance and skills necessary to gain financial freedom through real estate and live a debt free lifestyle". 
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