In an adjustable-rate mortgage, what does the index refer to?

In an adjustable-rate mortgage (ARM), the index is a crucial component that reflects the fluctuating cost of borrowing based on broader economic conditions. It serves as a benchmark that determines how much the interest rate of the loan will change when adjustments are made.

The index is typically tied to a financial indicator, such as the London Interbank Offered Rate (LIBOR) or the U.S. Treasury rates, which represents the lender's costs of obtaining funds in the market. As these rates rise or fall, the interest rate applied to the borrower's loan will also adjust accordingly, impacting their monthly payments.

Understanding the role of the index is essential for borrowers as it directly influences their future interest costs over the life of the loan. The chosen option correctly identifies this aspect, focusing on how the index acts as a variable component tied to lenders' cost of funds that ultimately affects the adjustable rate on the mortgage.