Index

Key Takeaways

• An index is a published market interest rate that an adjustable rate loan follows, and the lender neither sets it nor controls it.
• Index plus margin equals the fully indexed rate, which is the rate the borrower pays after an adjustment.
• The margin is fixed for the life of the loan while the index moves, so every rate change on an adjustable rate loan traces back to the index.
• A discounted introductory rate is not the index, and a loan can start below its fully indexed rate before adjusting up to it.

What It Means

An index is the outside benchmark that makes an adjustable rate loan adjustable. It is a published interest rate that moves up and down with general market conditions, such as a SOFR-based rate or a Treasury yield. The lender chooses which index a loan will follow and names it in the note, but the lender does not set its level and cannot move it. That independence is the whole point, because the borrower can look the number up.

The index never works alone. The lender adds a fixed margin, and index plus margin produces the fully indexed rate the borrower pays after each adjustment. The Margin stays the same for the life of the loan, so any change in the rate has to come from a movement in the index.

Two things sit between that arithmetic and the payment. Rate caps limit how far the rate can travel at a single adjustment and across the life of the loan, so a large index jump may be trimmed on its way to the borrower. A discounted start rate, sometimes called a teaser, can hold early payments below the fully indexed rate, so the first adjustment can raise the payment even if the index has not moved.

How It Works in Washington

In Washington the index is a disclosure duty before it is a payment. RCW 19.146.030 requires a mortgage broker to give the borrower a written disclosure stating, for a variable rate loan, the circumstances under which the rate may increase, any limitation on the increase, the effect of an increase, and an example of the payment terms resulting from an increase. A borrower shown only the discounted start rate has not been given what the statute asks for.

Washington also measures one loan feature directly from the index's first move. RCW 19.144.040 permits a prepayment penalty only where it expires at least sixty days before the initial reset period of an adjustable rate mortgage, and WAC 208-620-563 repeats the rule from the lender's side. The reset is the moment the index takes over from the start rate, so the state's Prepayment Penalty limit is counted backward from that date.

The loan itself is secured the ordinary Washington way, by a Deed Of Trust under chapter 61.24 RCW. RCW 61.24.020 provides that a deed conveying real property to a trustee in trust to secure performance of an obligation may be foreclosed by trustee's sale, and that remedy does not soften because the payment rose for a reason outside the borrower's control.

Example

Renata takes a 5/1 adjustable rate mortgage of $320,000 at a start rate of 5.5 percent over 30 years. Her principal and interest payment is $1,816.92. The note names an index, sets the margin at 2.75 percent, and caps the first adjustment at 2 percentage points.

Five years later the loan hits its first reset with a balance of $295,873.93. The index stands at 4.25 percent. Index plus margin is 4.25 plus 2.75, a fully indexed rate of 7.00 percent. The 2 point cap would have allowed anything up to 7.5 percent, so the cap does not bite and 7.00 percent becomes her new rate.

Recast over the 25 years remaining, that rate puts her payment at $2,091.18, an increase of $274.26 a month. The index moved, the margin did not, and the payment followed the index.

Common Mistakes and Exam Traps

• The index and the margin are not interchangeable. The index moves with the market, and the margin is fixed in the note for the life of the loan.
• The fully indexed rate is index plus margin, not the rate printed on the first payment coupon. A discounted start rate can sit well below it.
• A rate cap limits how far the rate can travel, but it does not change the index or the margin. Caps constrain the result of the arithmetic, not its inputs.
• The lender picks which index a loan follows but does not set that index's value, so a lender cannot raise a borrower's rate by moving the index.