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What Is an Index Loan?

Jim B.
Jim B.

An index loan is any loan with interest rates that are, at some point during the life of the loan, dependent upon some market index. Since these indexes can change over time, borrowers must be aware that interest payments may fluctuate every time the index moves. The most common form of index loan is an adjustable rate mortgage, or ARM, which allows home buyers to get a low, fixed rate in the early part of the mortgage. At some point, however, the interest rates with an ARM change and become tied to some index based on overall economic factors.

When a loan is agreed upon by two parties, the borrower often provides compensation to the lender against the risk of default by offering interest payments. These interest payments usually are determined by a percentage rate of the principal, which is the initial amount that was borrowed and must be returned. In some cases, this rate is determined at the onset of the loan and will not change. An index loan, by contrast, has rates that are tied to some index which is used as a kind of benchmark for loan rates in the locality where the loan is taking place.

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Most people who have experience with an index loan are those who have taken out adjustable rate mortgages. ARM's are so-named because the interest rate will not stay the same for the entire life of the mortgage. These rates may in fact fluctuate and affect how much the borrower pays each month.

Different countries use different indexes which can affect the rates paid on an index loan. In the United States, for example, two such indexes are the Constant Maturity Treasury index, or CMT, and the London Interbank Offered Rate, or LIBOR. Mortgage lenders have formulas which determine how changes in these indexes will affect the interest rates being paid by borrowers who have chosen adjustable rate mortgages.

In many cases, an ARM begins with a low, fixed interest rate to entice borrowers who may be short on initial funds. The agreement in such cases usually stipulates a certain point in the life of the loan when the rates will change, thus essentially making it an index loan. Even though borrowers know the point at which their rates may increase, they can't be sure of the severity of the increase. Since that is the case, an ARM is best suited to people who know that their income will have increased significantly by the time the interest rates begin to change.

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