Indexes

• Adjustable-rate mortgages are usually pegged to one or more financial indexes that measure prevailing market rates. According to the U.S. Federal Reserve Board, the most popular index rates to base rates on include the 1-Year Constant Maturity Treasury Rate (CMT), the Cost of Funds Index (COFI) and the London Interbank Offered Rate (LIBOR).
  
  

Margins

• In addition to index rates, interest rates on adjustable-rate mortgages are also calculated based on a set margin representing the percentage added to the index rate. For example, if the index rate was at 5 percent, and the margin is set at 2 percent, the borrower would pay an interest rate of 7 percent.
  
  

Considerations

• The margin added to the index rate is generally based on the creditworthiness of the borrower, measured primarily by their credit rating. Those with lower ratings must generally pay higher margins to compensate lenders for the increased risk of default.