Information on Adjustable
This document was designed
to help consumers understand an important and complex mortgage option
available to home buyers called adjustable rate mortgages.
We believe that 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 document can assist
you in providing information that can help you learn about adjustable
rate mortgages. This document won't provide all of the answers that 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 these questions better once you understand
more about adjustable-rate mortgages. This information 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 document 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 at the end
of this document. And a checklist at the end should also 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 and may go up or down accordingly.
Lenders generally charge lower
initial interest rates for ARMs than for 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 could 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 bills (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.
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 banks. 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.
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.
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
document 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.
Mortgage term: 30 years
One Year Index = 8%
Margin = 2%
ARM interest rate =10%
Monthly Payment @ 10% = $570.42
One-year index =8%
ARM interest rate = 11%
Monthly payment @11% = $619.01
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.
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 sale price of the home to cover the cost of
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
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 a 8% rate, your first 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 discounted 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
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.
year (w/discount) 8%
year @ 10%
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%.
year (w/discount) 8%
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
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.
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.
year @ 10%
year @13% (without cap)
year @12% (with cap)
Difference in 2nd year
between payment with cap 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 payments
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%.
year @ 10%
index rises 3%...
year @12% (with 2% rate cap)
the index stays the same for the 3rd year @13%
though index stays the same in 3rd year, payment goes up
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.
year @10 %
year @19% (without cap)
year @ 15% (with cap)
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.
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 1/2% payment cap, a payment of $100 could increase to no more than
$107.50 in the first adjustment period, and to no more than $155.56 in
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 1/2% in any one year. Here's what your payments
would look like:
year @ 12% (without payment caps)
year @ 12% (with 7 1/2% payment cap)
Many ARMs with payment
caps do not have periodic interest rate caps.
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 long 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
1/2% 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
Loan amount @ end of
first year = $64,638.72
during 2nd year = $420.90
Loan amount @ end of
22nd year = $65,059.62 ($64,638.72 + $420.90)
(If you sold your house
at this point, you would owe almost $60 more than the amount you originally
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.
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
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 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.
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, with out emphasizing that those rates and payments could later
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.
lenders -- and
ask questions --
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 end of this document is intended
to help you compare terms on different loans.
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 plan.
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).
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 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.
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.
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.
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.
In an ARM with an initial rate
discount, the lender gives up a number of percentage points in interest
to give you 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.
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. 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.
The number of percentage points
the lender adds to the index rate to calculate the ARM interest rate at
Amortization means that monthly
payments are not large enough to pay the interest and reduce the principal
on your mortgage. Negative amortization occurs when the monthly payment
does 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
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.
Ask your lender
to help fill out this checklist.
Basic Features for
Fixed-rate annual percentage
(The cost of your credit as
rate which includes both interest
and other charges) __________________________
ARM annual percentage rate
Adjustment period ____________________________________
Index used and current rate
Initial payment without discount
Initial payment with discount
(if any) ____________________________________
How long will discount last?
Interest rate caps: periodic
Payment caps ____________________________________
Negative amortization ____________________________________
Convertibility or prepayment
Initial fees and charges ____________________________________
Monthly Payment Amounts
What will my monthly payment
twelve months if the index
rate stays the
goes up 2% ____________________________________
goes down 2% ____________________________________
What will my monthly payments
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.
* Courtesy of The Federal Reserve
Board and the Office of Thrift Supervision