Consumer Handbook on Adjustable Rate Mortgages
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Federal Reserve Board
Office of Thrift supervision
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EQUAL HOUSING OPPORTUNITY
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.
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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.
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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.
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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%.
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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.
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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.
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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%.
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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.
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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:
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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.
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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.
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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.
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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.
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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.