Adjustable rate loans have an initial interest rate set for a fixed term, thereafter, the rate on the loan resets based on a stated term at a spread over/(under) some market index.
That index could be based on the prime rate, certain maturities of US or foreign government treasuries, Libor/swap curve, brokered CDs, cost of funds, or a bank or financial institution’s self-defined index.
The purpose of adjustable rate loans is to provide a degree of interest rate protection to the bank or credit union while allowing it to offer a longer maturity loan to a borrower. PrecisionLender allows for this rate type:
When the rate type selected is adjustable, additional entries must be made above those required for a fixed rate loan. These are:
- The index that will be used at the time of adjustment
- There are up to six families of indices that can be selected. The custom index is usually only shown if the institution uses an internal index that is put into PrecisionLender. The institution’s model administrator can also choose to eliminate other families of indices. PrecisionLender will default to the family set by the institution.
- The maturity of the index that will be used
- Once the family is chosen, PrecisionLender will show the index with the maturity closest to the given period in the Adjustment Frequency. The current rate for the index at that maturity is also shown. In the case below, the adjustment frequency was set at 12, so the index is assumed to be a 12-month treasury rate.
- If the Adjustment Frequency changes, as long as the maturity period is set to Auto: (this is available as a default selection and is shown in the image below), the index maturity will automatically update to the closet rate where appropriate.
- For example, if the Adjustment Frequency changes from 12 months to 24 months, the rate will change from Treasury 1-Year to Treasury 2-Year.
- If a specific maturity period is being used (i.e. a 3-year treasury), then the user can select that maturity from the dropdown. However, once selected, the index maturity will not automatically update if the Adjustment Frequency is updated.
- For example, if you changed the maturity from Auto: to Treasury 3-Year, with a 36 month Adjustment Frequency, a reduction of the Adjustment Frequency to 12 months will still retain the Treasury 3-Year rate.
- If the product settings have been configured so that the index is locked at the adjustment frequency maturity point (or the closest maturity point to the adjustment frequency) for the selected Index, then this field will be read-only and you cannot change to a maturity point for the index that differs from the adjustment frequency. Any change to the adjustment frequency will automatically update to the closest maturity point.
- The spread to the index at time of adjustment
- This is usually some positive amount, although when prime is the index, it may occasionally be negative. PrecisionLender will recommend a spread that will meet the target.
- The total of the spread and the rate of the selected index will appear in the Initial Rate field.
- Note: Making a change to the initial rate field will not change the spread. The spread must be changed in order to change the initial rate.
- A cap and/or floor can also be chosen. For more information on using caps and floors, please click here.
- The fixed period
- The fixed period is the time frame that the initial rate is in effect. If the initial period is 60 months and the interest rate resets for every 12 months thereafter, enter 60. The time period shown is always in months. If the initial period is one year, 12 should be entered. If the fixed period is disabled by entering 0 months, the 'Initial Rate' field will become display-only with an explanation of the factors that produced the initial rate. The rate can be changed by adjusting the index or the spread. (Note: This field will not appear if the Fixed Period has been disabled at the product level.)
- The adjustment frequency
- Adjustment frequency is the time period, in months, when the reset rate is effective. Here are a few examples of this in practice:
- Example 1: If a loan has an initial period of 60 months, reset for another 60 months (so called 5-5 adjustable), and has a term of 120 months, enter 60 for the adjustment frequency. While you may want to enter 1 because there's only one reset, doing so means that the rate would reset monthly, and cause problems with cost of funds calculations. Only enter 1 if the rate after the initial period is floating and can reset on a monthly or more frequent basis.
- Example 2: If the term of a loan is 96 months, has an initial period of 36 months, and has an adjustment period of 24 months, enter 24 for the adjustment frequency, even though the last adjustment might only be for 12 months (see table below).
Months Rate 1-36 Fixed Rate 37-60 Index+Spread from month 37 61-84 Index+Spread from month 61 85-96 Index+Spread from month 85