Fixed vs. Adjustable rate mortgages.

Almost one-third of mortgage applicants nowadays are getting adjustable-rate mortgages, or ARMs. The hardest-to-understand element of an ARM is the index. 

When you get an ARM, two main factors determine the rate you pay: the index and the margin. The index is a rate set by market forces and published by a neutral third party. The margin is an agreed-upon number of percentage points that is added to the index to determine your rate.

A thorough mortgage shopper will run across a bunch of acronyms to denote various ARM indexes, such as COFI, LIBOR, MAT and CMT. Each index responds at its own peculiar pace to the economy's ups and downs.

Indexes can be divided into two broad categories: those based upon rate averages and those based upon more volatile spot rates. There is some overlap between the two categories. ARMs indexed to average rates tend to move more slowly, in rather gradual steps, whether the markets are rising or falling. ARMs based on spot rates go up and down abruptly.  

Larry Goldstone, president of Thornburg Mortgage, a portfolio lender that does only ARMs, says that ARMs based on averages tend to have higher margins than ARMs based on spot rates.

Someone who gets an ARM indexed to rate averages "gets one benefit and one drawback," Goldstone says. "The benefit is that, in a changing rate environment, an average index will move more slowly, so the payment changes more slowly. The drawback is that the margin typically is higher, and so the rate you pay is higher."

Indexes based on average rates include the 11th District Cost of Funds Index (COFI) and the 12-month Treasury average.

Of indexes based on spot rates, among the most popular is the LIBOR, for London Interbank Offered Rate. Then there is the constant maturity Treasury, or CMT, index, which comes from a short-term average that acts more like a spot rate. Other spot indexes are based on the prime rate and yields on certificates of deposit.

"If a consumer is looking at different ARMs with different index options, it's a good idea to look at different graphs," says Garrett Brief, vice president for product development for mortgage lender IndyMac Bank. Graphs of each loan type's fluctuations will help you understand how rapidly and how much the rates change.

Here is a rundown of some of the popular types of adjustable-rate mortgages, how they work and who they are suited for:

11th District Cost of Funds Index (COFI) index: Rates on COFI-indexed mortgages move up and down slowly. With most COFI-based loans, the rate is adjusted every month and the monthly payment is adjusted once a year. This means that some borrowers can end up owing more than they borrowed if their payments don't cover all the interest due, a phenomenon called "negative amortization."

COFI-based loans are indexed to the cost of funds for the 11th district of the Federal Home Loan Bank system. The 11th district consists of banks based in Arizona, California and Nevada. The cost of funds index is a weighted average of the interest that member banks pay on money they borrow, mostly on customers' checking and savings accounts.

Anyone who has had a savings, money market or interest-bearing savings account knows that those rates are low and move tortoise-like. The COFI (pronounced "coffee") is calculated at the end of every month for the previous month, so it lags the overall market. The COFI's slow, lagging pace benefits borrowers when rates are rising, but not when rates are falling.

12-month Treasury average (MTA) indexes: Rates on ARMS indexed to the 12-month average of the one-year Treasury bill are usually called the "12 MTA." Every month, the U.S. Treasury calculates and publishes the average yield on a constant-maturity 1-year Treasury bill for the previous month. The 12 MTA index takes the average of the last 12 averages.

 Like the COFI, the rate on a 12 MTA is adjusted every month. Depending on the loan program, the monthly payment might be adjusted every month or once a year. 

Rates indexed to the last 12 monthly averages for 1-year Treasuries move slowly. "If interest rates were to go up 100 basis points tomorrow," says Goldstone -- in other words, if they rose 1 percentage point -- "that index would go up only one-twelfth of 1 percent the next month. And then the second twelfth the next month, and so on." The 12 MTA index reacts slowly to fluctuations in short-term rates and smoothes them out.

London Interbank Offered Rate (LIBOR) indexes: The LIBOR (pronounced LIE-bore) tracks the rates at which London banks pay to borrow one another's reserves. It fluctuates more rapidly than the COFI or 12 MTA. The LIBOR is sort of a rough equivalent of the federal funds rate in the United States, but it is set by the market, not a government entity.