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.
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 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.
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%.
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.
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:
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.
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.
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.
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.
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.
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.
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. 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.
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.
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 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.
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 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.
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.
The number of percentage points the lender
adds to the index rate to calculate the ARM interest rate at each adjustment.
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.
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.
Payment Shock
ARM Interest Rate Monthly Payment
----------------- ---------------
First year (w/ discount) 8% $476.95
2nd year @ 10% $568.82
ARM Interest Rate Monthly Payment
----------------- ---------------
First year (w/ discount) 8% $476.95
2nd year @ 12% $665.43
HOW CAN I REDUCE MY RISK?
Interest-Rate Caps
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
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.)
Prepayment and Conversion
WHERE TO GET INFORMATION
Advertising
Get all the facts.
Disclosures From Lenders
GLOSSARY
Annual Percentage Rate (APR)
Adjustable-Rate Mortgage (ARM)
Assumability
Buydown
Cap
Conversion Clause
Discount
Index
Margin
Negative Amortization
Points
MORTGAGE 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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