If you're wondering how to compare loans, two of the most important elements to look at are the index and margin. These are especially important in ARMs, which feature varying rates of interest and flexible monthly payments.

The Index

An index is essentially a base rate of interest from which your lender establishes the interest actually used on your mortgage. If you have an adjustable-rate mortgage, your lender uses the index not only for the initial calculation of interest, but also for every subsequent recalculation after your introductory period is over. Most indices are market-based and are set independently from the lenders. Common indices used today include the London Interbank Offered Rate (LIBOR), Cost of Funds Index (COFI) and Constant-Maturity Treasury (CMT).

You can categorize indices broadly as either average or spot rate. Typically, if your mortgage uses an average index, you'll find that your payments are slightly higher but shift much more slowly. With a spot index, the changes are much more volatile, and subsequently, so are your payments, despite them being a little lower.

The Margin

Margin refers to a set percentage that your lender adds to your interest rate. For instance, you're your interest rate based on your given index is 4%, and your margin is 2%, then your final interest rate for the mortgage would be 6%. Unlike the index, your mortgage margin is not market-based and independent, but rather is determined by the specific lender you're working with. Lenders typically keep margins at 4% or lower, but if your credit is not so great, you might see a margin as steep as 7%. Combined with the index percentage, this can yield a very unfavorable mortgage arrangement.

Understanding and Applying Index and Margin in Loan Comparison

Aside from selecting which index to use, mortgage lenders have very little control over the index portion of your final interest rate. If you want to get a picture of whether the indices they have selected will provide favorable financial results for you, your best bet is to look at graphs that show how the different indices have changed over time, as Holden Lewis of Bankrate suggests. This not only gives clues about the kind of rate increases you might expect, but also how quickly the fluctuations are happening. This is very important because most lenders often attract potential ARM borrowers with attractive rates of interest offered only for the introductory period. Unless you know how the index likely will perform over the long haul, your adjustments--particularly the initial one, which often isn't subject to an interest rate cap--might be quite of a shock.

Looking at margin, lenders are going to offer you a percentage based primarily on the risk they perceive you to be. If your credit is low, they might spike the margin in order to protect themselves from the potential loss that could happen should you default. For this reason, even though lenders consider many other elements when drawing up a mortgage package, you want to do everything you can to get your credit score up before you start applying. Sometimes, you can get the lender to reduce the margin by offering some collateral, offering a larger down-payment or getting one or more cosigners on the loan. You should ask what the lender can offer to you in these various scenarios.

Conclusion

The index and margin related to a mortgage are often confusing, especially for first-time home buyers. These figures work together to determine the bulk of your mortgage cost, not including fees such as origination or closing. You have some control over them in that you can select lenders that use specific indices that are yielding the type of performance you need over time, and in that you can negotiate for a lower margin through techniques such as getting a cosigner. The more you know about the indices out there when you are considering your home purchase, and the more questions you ask of your lender to see how different circumstances might influence your margin, the more likely it is that you'll come out on top when you go through the comparison process.