What Is an Index in Loans?
On any adjustable rate loan, the interest rate is set based on an underlying index and a margin. The margin stays the same overtime, but the index varies based on an underlying indicator.
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Structure
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The underlying index on a loan is any financial indicator agreed upon at the beginning of the loan. For example, the national prime rate can be used as an index. If your adjustable rate loan is capped at 2.5 percent over this index, and the national prime rate moves from 2 percent to 4 percent, your loan interest rate will move from 4.5 percent to 6.5 percent.
Application
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Adjustable rate loans are popular for borrowers who believe their ability to pay will rise in the future. By setting an initial rate below a market index, they have low initial monthly payments. After anywhere from one to five years, the rate begins to adjust at index. At this point, the borrower ideally has more money available to afford the higher rates.
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Expert Insight
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Compare different mortgage indexes before signing your loan contract. If you have an index that tends to be higher than others, match it with a lower margin in order to get the most competitive rates.
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References
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