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Consumer Handbook on Adjustable Rate Mortgages
Prepared by the Federal Reserve Board
and the Office of Thrift Supervision
This booklet was prepared in consultation with the following
organizations:
- American Bankers Association
- Comptroller of the Currency
- Consumer Federation of America
- Credit Union National Association, Inc.
- Federal Deposit Insurance Corporation
- Federal Reserve Board's Consumer Advisory Council
- Federal Trade Commission
- Independent Bankers Association of America
- Mortgage Bankers Association of America
- Mortgage Insurance Companies of America
- National Association of Federal Credit Unions
- National Association of Home Builders
- National Association of Realtors
- National Council of Savings Institutions
- National Credit Union Administration
- Office of Special Advisor to the President for Consumer Affairs
- The Consumer Bankers Association
- U.S. Department of Housing and Urban Development
- U.S. League of Savings Institutions
With special thanks to the Federal National Mortgage Association and the
Federal Home Loan Mortgage Corporation.
The Federal Reserve Board and the Office of Thrift Supervision prepared
this booklet on adjustable rate mortgages (ARMs) in response to a request
from the House Committee on Banking, Finance and Urban Affairs and in
consultation with many other agencies and trade and consumer groups. It is
designed to help consumers understand an important and complex mortgage
option available to home buyers.
We believe a fully informed consumer is in the best position to make a
sound economic choice. If you are buying a home, and looking for a home
loan, this booklet will provide useful basic information about ARMs. It
cannot provide all the answers you will need, but we believe it is a good
starting point.
PEOPLE ARE ASKING...
"Some newspaper ads for home loans show surprisingly low rates. Are
these loans for real, or is there a catch?"
Some of the ads you see are for adjustable rate mortgages (ARMs). These
loans may have low rates for a short time--maybe only for the first year.
After that, the rates can be adjusted on a regular basis. This means that
the interest rate and the amount of the monthly payment can go up or down.
"Will I know in advance how much my payment may go up?"
With an adjustable-rate mortgage, your future monthly payment is
uncertain. Some types of ARMs put a ceiling on your payment increase or rate
increase from one period to the next. Virtually all must put a ceiling on
interest- rate increases over the life of the loan.
"Is an ARM the right type of loan for me?"
That depends on your financial situation and the terms of the ARM. ARMs
carry risks in periods of rising interest rates, but can be cheaper over a
longer term if interest rates decline. You will be able to answer the
question better once you understand more about adjustable-rate mortgages.
This booklet should help.
Mortgages have changed, and so have the questions that need to be asked
and answered.
Shopping for a mortgage used to be a relatively simple process. Most home
mortgage loans had interest rates that did not change over the life of the
loan. Choosing among these fixed-rate mortgage loans meant comparing
interest rates, monthly payments, fees, prepayment penalties, and due-on-
sale clauses.
Today, many loans have interest rates (and monthly payments) that can
change from time to time. To compare one ARM with another or with a fixed-
rate mortgage, you need to know about indexes, margins, discounts, caps,
negative amortization, and convertibility. You need to consider the maximum
amount your monthly payment could increase. Most important, you need to
compare what might happen to your mortgage costs with your future ability to
pay.
This booklet explains how ARMs work and some of the risks and advantages
to borrowers that ARMs introduce. It discusses features that can help reduce
the risks and gives some pointers about advertising and other ways you can
get information from lenders. Important ARM terms are defined in a glossary
on page 19. And a checklist at the end of the booklet should help you ask
lenders the right questions and figure out whether an ARM is right for you.
Asking lenders to fill out the checklist is a good way to get the
information you need to compare mortgages.
WHAT IS AN ARM?
With a fixed-rate mortgage, the interest rate stays the same during the
life of the loan. But with an ARM, the interest rate changes periodically,
usually in relation to an index, and payments may go up or down accordingly.
Lenders generally charge lower initial interest rates for ARMs than for
fixed-rate mortgages. This makes the ARM easier on your pocketbook at first
than a fixed-rate mortgage for the same amount. It also means that you might
qualify for a larger loan because lenders sometimes make this decision on
the basis of your current income and the first year's payments. Moreover,
your ARM could be less expensive over a long period than a fixed-rate
mortgage--for example, if interest rates remain steady or move lower.
Against these advantages, you have to weigh the risk that an increase in
interest rates would lead to higher monthly payments in the future. It's a
trade-off--you get a lower rate with an ARM in exchange for assuming more
risk.
Here are some questions you need to consider:
- Is my income likely to rise enough to cover higher mortgage payments
if interest rates go up?
- Will I be taking on other sizable debts, such as a loan for a car or
school tuition, in the near future?
- How long do I plan to own this home? (If you plan to sell soon, rising
interest rates may not pose the problem they do if you plan to own the
house for a long time.)
- Can my payments increase even if interest rates generally do not
increase?
HOW ARMS WORK: THE BASIC FEATURES
The Adjustment Period
With most ARMs, the interest rate and monthly payment change every year,
every three years, or every five years. However, some ARMs have more
frequent interest and payment changes. The period between one rate change
and the next is called the adjustment period. So, a loan with an adjustment
period of one year is called a one-year ARM, and the interest rate can
change once every year.
The Index
Most lenders tie ARM interest rate changes to changes in an "index rate."
These indexes usually go up and down with the general movement of interest
rates. If the index rate moves up, so does your mortgage rate in most
circumstances, and you will probably have to make higher monthly payments.
On the other hand, if the index rate goes down your monthly payment may go
down.
Lenders base ARM rates on a variety of indexes. Among the most common are
the rates on one-, three-, or five-year Treasury securities. Another common
index is the national or regional average cost of funds to savings and loan
associations. A few lenders use their own cost of funds, over which--unlike
other indexes--they have some control. You should ask what index will be
used and how often it changes. Also ask how it has behaved in the past and
where it is published.
The Margin
To determine the interest rate on an ARM, lenders add to the index rate a
few percentage points called the "margin." The amount of the margin can
differ from one lender to another, but it is usually constant over the life
of the loan.
Index rate + margin = ARM interest rate
Let's say, for example, that you are comparing ARMs offered by two
different lenders. Both ARMs are for 30 years and an amount of $65,000. (All
the examples used in this booklet are based on this amount for a 30- year
term. Note that the payment amounts shown here do not include items like
taxes or insurance.)
Both lenders use the one-year Treasury index. But the first lender uses a
2% margin, and the second lender uses a 3% margin. Here is how that
difference in margin would affect your initial monthly payment.
Home sale price: $85,000
Less down payment: -20,000
-------
Mortgage amount: $65,000
Mortgage term: 30 years
First Lender
------------
One-year index = 8%
Margin = 2%
ARM interest rate = 10%
Monthly payment @ 10% = $570.52
Second Lender
-------------
One-year index = 8%
Margin = 3%
ARM interest rate = 11%
Monthly payment @ 11% = $691.01
In comparing ARMs, look at both the index and margin for each plan. Some
indexes have higher average values, but they are usually used with lower
margins. Be sure to discuss the margin with your lender.
CONSUMER CAUTIONS
Discounts
Some lenders offer initial ARM rates that are lower than the sum of the
index and the margin. Such rates, called discounted rates, are often
combined with large initial loan fees ("points") and with much higher
interest rates after the discount expires.
Very large discounts are often arranged by the seller. The seller pays an
amount to the lender so the lender can give you a lower rate and lower
payments early in the mortgage term. This arrangement is referred to as a
"seller buydown." The seller may increase the sales price of the home to
cover the cost of the buydown.
A lender may use a low initial rate to decide whether to approve your
loan, based on your ability to afford it. You should be careful to consider
whether you will be able to afford payments in later years when the discount
expires and the rate is adjusted.
Here is how a discount might work. Let's assume the one-year ARM rate
(index rate plus margin) is at 10%. But your lender is offering an 8% rate
for the first year. With the 8% rate, your first year monthly payment would
be $476.95.
But don't forget that with a discounted ARM, your low initial payment
will probably not remain low for long, and that any savings during the
discount period may be made up during the life of the mortgage or be
included in the price of the house. In fact, if you buy a home using this
kind of loan, you run the risk of...
Payment Shock
Payment shock may occur if your mortgage payment rises very sharply at
the first adjustment. Let's see what happens in the second year with your
discounted 8% ARM.
ARM Interest Rate Monthly Payment
----------------- ---------------
First year (w/ discount) 8% $476.95
2nd year @ 10% $568.82
As the example shows, even if the index rate stays the same, your monthly
payment would go up from $476.95 to $568.82 in the second year.
Suppose that the index rate increases 2% in one year and the ARM rate
rises to a level of 12%.
ARM Interest Rate Monthly Payment
----------------- ---------------
First year (w/ discount) 8% $476.95
2nd year @ 12% $665.43
That's an increase of almost $200 in your monthly payment. You can see
what might happen if you choose an ARM impulsively because of a low initial
rate. You can protect yourself from increases this big by looking for a
mortgage with features, described next, which may reduce this risk.
HOW CAN I REDUCE MY RISK?
Besides an overall rate ceiling, most ARMs also have "caps" that protect
borrowers from extreme increases in monthly payments. Others allow borrowers
to convert an ARM to a fixed-rate mortgage. While these may offer real
benefits, they may also cost more, or add special features, such as negative
amortization.
Interest-Rate Caps
An interest-rate cap places a limit on the amount your interest rate can
increase. Interest caps come in two versions:
- Periodic caps, which limit the interest rate increase from one
adjustment period to the next; and
- Overall caps, which limit the interest-rate increase over the life of
the loan.
By law, virtually all ARMs must have an overall cap. Many have a periodic
interest rate cap.
Let's suppose you have an ARM with a periodic interest rate cap of 2%. At
the first adjustment, the index rate goes up 3%. The example shows what
happens.
ARM Interest Rate Monthly Payment
----------------- ---------------
First year @ 10% $570.42
2nd year @ 13%
(without cap) $717.42
2nd year @ 12%
(with cap) $667.30
Difference in 2nd year between payment with cap
and payment without = $49.82
A drop in interest rates does not always lead to a drop in monthly
payments. In fact, with some ARMs that have interest rate caps, your payment
amount may increase even though the index rate has stayed the same or
declined. This may happen after an interest rate cap has been holding your
interest rate down below the sum of the index plus margin.
With some ARMs, payment may increase
even if the index rate stays the same or declines.
Look below at the example where there was a periodic cap of 2% on the
ARM, and the index went up 3% at the first adjustment. If the index stays
the same in the third year, your rate would go up to 13%.
ARM Interest Rate Monthly Payment
----------------- ---------------
First year @ 10% $570.42
If index rises 3%...
2nd year @ 12%
(with 2% rate cap) $667.30
If the index stays the same
for the 3rd year @ 13% $716.56
Even though index stays the same in 3rd year,
payment goes up $49.26
In general, the rate on your loan can go up at any scheduled adjustment
date when the index plus the margin is higher than the rate you are paying
before that adjustment. The next example shows how a 5% overall rate cap
would affect your loan.
ARM Interest Rate Monthly Payment
----------------- ---------------
First year @ 10% $570.42
10th year @ 19%
(without cap) $1,008.64
10th year @ 15%
(with cap) $813.00
Let's say that the index rate increases 1% in each of the first ten
years. With a 5% overall cap, your payment would never exceed
$813.00--compared to the $1,008.64 that it would have reached in the tenth
year based on a 19% indexed rate.
Payment Caps
Some ARMs include payment caps, which limit your monthly payment increase
at the time of each adjustment, usually to a percentage of the previous
payment. In other words, with a 7«% payment cap, a payment of $100 could
increase to no more than $107.50 in the first adjustment period, and to no
more than $115.56 in the second.
Let's assume that your rate changes in the first year by 2 percentage
points, but your payments can increase by no more than 7«% in any one year.
Here's what your payments would look like:
ARM Interest Rate Monthly Payment
----------------- ---------------
First year @ 10% $570.42
2nd year @ 12%
(without payment cap) $667.30
2nd year @ 12%
(with 7 1/2% payment cap) $613.20
Difference in monthly payment=$54.10
Many ARMs with payment caps do not have periodic interest rate caps.
Negative Amortization
If your ARM contains a payment cap, be sure to find out about "negative
amortization." Negative amortization means the mortgage balance is
increasing. This occurs whenever your monthly mortgage payments are not
large enough to pay all of the interest due on your mortgage.
Because payment caps limit only the amount of payment increases, and not
interest-rate increases, payments sometimes do not cover all of the interest
due on your loan. This means that the interest shortage in your payment is
automatically added to your debt, and interest may be charged on that
amount. You might therefore owe the lender more later in the loan term than
you did at the start. However, an increase in the value of your home may
make up for the increase in what you owe.
The next illustration uses the figures from the preceding example to show
how negative amortization works during one year. Your first 12 payments of
$570.42, based on a 10% interest rate, paid the balance down to $64,638.72
at the end of the first year. The rate goes up to 12% in the second year.
But because of the 7«% payment cap, payments are not high enough to cover
all the interest. The interest shortage is added to your debt (with interest
on it), which produces negative amortization of $420.90 during the second
year.
Beginning loan amount = $65,000
-------------------------------
Loan amount @ end of first year = $64,638.72
Negative amortization during 2nd year = $420.90
Loan amount @ end of 2nd year = $65,059.62
(If you sold your house at this point, you would owe
almost $60 more than the amount you originally borrowed.)
To sum up, the payment cap limits increases in your monthly payment by
deferring some of the increase in interest. Eventually, you will have to
repay the higher remaining loan balance at the ARM rate then in effect. When
this happens, there may be a substantial increase in your monthly payment.
Some mortgages contain a cap on negative amortization. The cap typically
limits the total amount you can owe to 125% of the original loan amount.
When that point is reached, monthly payments may be set to fully repay the
loan over the remaining term, and your payment cap may not apply. You may
limit negative amortization by voluntarily increasing your monthly payment.
Be sure to discuss negative amortization with the lender to understand
how it will apply to your loan.
Prepayment and Conversion
If you get an ARM and your financial circumstances change, you may decide
that you don't want to risk any further changes in the interest rate and
payment amount. When you are considering an ARM, ask for information about
prepayment and conversion.
Prepayment. Some agreements may require you to pay special fees or
penalties if you pay off the ARM early. Many ARMs allow you to pay the loan
in full or in part without penalty whenever the rate is adjusted. Prepayment
details are sometimes negotiable. If so, you may want to negotiate for no
penalty, or for as low a penalty as possible.
Conversion. Your agreement with the lender can have a clause that lets
you convert the ARM to a fixed-rate mortgage at designated times. When you
convert, the new rate is generally set at the current market rate for
fixed-rate mortgages.
The interest rate or up-front fees may be somewhat higher for a
convertible ARM. Also, a convertible ARM may require a special fee at the
time of conversion.
WHERE TO GET INFORMATION
Before you actually apply for a loan and pay a fee, ask for all the
information the lender has on the loan you are considering. It is important
that you understand index rates, margins, caps, and other ARM features like
negative amortization. You can get helpful information from advertisements
and disclosures, which are subject to certain federal standards.
Advertising
Your first information about mortgages probably will come from newspaper
advertisements placed by builders, real estate brokers, and lenders. While
this information can be helpful, keep in mind that the ads are designed to
make the mortgage look as attractive as possible. These ads may play up low
initial interest rates and monthly payments, without emphasizing that those
rates and payments later could increase substantially. Get all the facts.
A federal law, the Truth in Lending Act, requires mortgage advertisers,
once they begin advertising specific terms, to give further information on
the loan. For example, if they want to show the interest rate or payment
amount on the loan, they must also tell you the annual percentage rate (APR)
and whether that rate may go up. The annual percentage rate, the cost of
your credit as a yearly rate, reflects more than just a low initial rate. It
takes into account interest, points paid on the loan, any loan origination
fee, and any mortgage insurance premiums you may have to pay.
Ads may play up low initial rates.
Get all the facts.
Disclosures From Lenders
Federal law requires the lender to give you information about adjustable-
rate mortgages, in most cases before you apply for a loan. The lender also
is required to give you information when you get a mortgage. You should get
a written summary of important terms and costs of the loan. Some of these
are the finance charge, the annual percentage rate, and the payment terms.
Read information from lenders -- and
ask questions -- before committing yourself.
Selecting a mortgage may be the most important financial decision you
will make, and you are entitled to all the information you need to make the
right decision. Don't hesitate to ask questions about ARM features when you
talk to lenders, real estate brokers, sellers, and your attorney, and keep
asking until you get clear and complete answers. The checklist at the back
of this pamphlet is intended to help you compare terms on different loans.
GLOSSARY
Annual Percentage Rate (APR)
A measure of the cost of credit, expressed as a yearly rate. It includes
interest as well as other charges. Because all lenders follow the same rules
to ensure the accuracy of the annual percentage rate, it provides consumers
with a good basis for comparing the cost of loans, including mortgage plans.
Adjustable-Rate Mortgage (ARM)
A mortgage where the interest rate is not fixed, but changes during the
life of the loan in line with movements in an index rate. You may also see
ARMs referred to as AMLs (adjustable mortgage loans) or VRMs (variable- rate
mortgages).
Assumability
When a home is sold, the seller may be able to transfer the mortgage to
the new buyer. This means the mortgage is assumable. Lenders generally
require a credit review of the new borrower and may charge a fee for the
assumption. Some mortgages contain a due-on-sale clause, which means that
the mortgage may not be transferable to a new buyer. Instead, the lender may
make you pay the entire balance that is due when you sell the home.
Assumability can help you attract buyers if you sell your home.
Buydown
With a buydown, the seller pays an amount to the lender so that the
lender can give you a lower rate and lower payments, usually for an early
period in an ARM. The seller may increase the sales price to cover the cost
of the buydown. Buydowns can occur in all types of mortgages, not just ARMs.
Cap
A limit on how much the interest rate or the monthly payment can change,
either at each adjustment or during the life of the mortgage. Payment caps
don't limit the amount of interest the lender is earning, so they may cause
negative amortization.
Conversion Clause
A provision in some ARMs that allows you to change the ARM to a
fixed-rate loan at some point during the term. Usually conversion is allowed
at the end of the first adjustment period. At the time of the conversion,
the new fixed rate is generally set at one of the rates then prevailing for
fixed rate mortgages. The conversion feature may be available at extra cost.
Discount
In an ARM with an initial rate discount, the lender gives up a number of
percentage points in interest to give you a lower rate and lower payments
for part of the mortgage term (usually for one year or less). After the
discount period, the ARM rate will probably go up depending on the index
rate.
Index
The index is the measure of interest rate changes that the lender uses to
decide how much the interest rate on an ARM will change over time. No one
can be sure when an index rate will go up or down. To help you get an idea
of how to compare different indexes, the following chart shows a few common
indexes over a ten-year period (1977-87). As you can see, some index rates
tend to be higher than others, and some more volatile. (But if a lender
bases interest rate adjustments on the average value of an index over time,
your interest rate would not be as volatile.) You should ask your lender how
the index for any ARM you are considering has changed in recent years, and
where it is reported.
Margin
The number of percentage points the lender adds to the index rate to
calculate the ARM interest rate at each adjustment.
Negative Amortization
Amortization means that monthly payments are large enough to pay the
interest and reduce the principal on your mortgage. Negative amortization
occurs when the monthly payments do not cover all of the interest cost. The
interest cost that isn't covered is added to the unpaid principal balance.
This means that even after making many payments, you could owe more than you
did at the beginning of the loan. Negative amortization can occur when an
ARM has a payment cap that results in monthly payments not high enough to
cover the interest due.
Points
A point is equal to one percent of the principal amount of your mortgage.
For example, if you get a mortgage for $65,000, one point means you pay $650
to the lender. Lenders frequently charge points in both fixed-rate and
adjustable-rate mortgages in order to increase the yield on the mortgage and
to cover loan closing costs. These points usually are collected at closing
and may be paid by the borrower or the home seller, or may be split between
them.
MORTGAGE CHECKLIST
Ask your lender to help fill out this checklist.
Mortgage A Mortgage B
Mortgage amount
Basic Features for Comparison
Fixed-rate annual percentage rate __________ __________
(the cost of your credit as a
yearly rate which includes both
interest and other charges)
ARM annual percentage rate __________ __________
Adjustment period __________ __________
Index used and current rate __________ __________
Margin __________ __________
Initial payment without discount __________ __________
Initial payment with discount
(if any) __________ __________
How long will discount last? __________ __________
Interest rate caps: periodic __________ __________
overall __________ __________
Payment caps __________ __________
Negative amortization __________ __________
Convertibility or prepayment
privilege __________ __________
Initial fees and charges __________ __________
Monthly Payment Amounts
What will my monthly payment be after twelve months if the index rate:
stays the same __________ __________
goes up 2% __________ __________
goes down 2% __________ __________
What will my monthly payments be after three years if the index rate:
stays the same __________ __________
goes up 2% per year __________ __________
goes down 2% per year __________ __________
Take into account any caps on your mortgage and remember it may run 30
years.
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