What is a Fully Indexed Interest Rate?

A fully indexed interest rate equals an adjustable-rate mortgage's (ARM) interest rate benchmark plus a spread.

How Does a Fully Indexed Interest Rate Work?

The interest rate on an ARM corresponds to a specific benchmark (often the prime rate, but sometimes LIBOR, the one-year constant-maturity Treasury, or other benchmarks) plus a spread (also called the margin, and its size is often based on the borrower's credit score). The benchmark plus the spread equals the interest rate on the loan; it is called the fully indexed rate. Some ARMs offer a discounted index rate, also called a teaser rate, during the first year or so. For example, if the prime rate is 4%, and the interest rate is prime plus 5% with a cap of 10%, then the loan's fully indexed interest rate is 9% (5% + 4%).

Why Does a Fully Indexed Interest Rate Matter?

In many cases, ARMs have caps -- limits on how high and sometimes how low the interest rate can go, and how much they can move in a year, month or quarter. In some cases, the interest rate will only adjust up -- that is, borrowers get no benefit if interest rates fall.

For example, if a borrower takes an interest-only ARM that currently carries a 7% interest rate, he hopes rates will drop and his payments will fall accordingly; the lender, on the other hand, hopes interest rates will increase, which raises the amount of profit the loan generates (by increasing the borrower's payments). Because of this risk arrangement, ARMs often carry lower interest rates than fixed-rate mortgages, which in turn might allow borrowers to borrow more than they could under fixed-rate mortgages.

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