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Consumer Handbook on Adjustable Rate Mortgages
This booklet was originally prepared in consultation with the following organizations: American Bankers Association With special thanks to Fannie Mae (formerly the Federal National Mortgage Association) and Freddie Mac (formerly the Federal Home Loan Mortgage Corporation). The Federal Reserve Board and the Office of Thrift Supervision prepared this booklet on adjustablerate 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?" "Will I know in advance how much my payment may go up?" "Is an ARM the right type of loan for me?" Mortgages have changed, and so have the questions that consumers need to ask and have 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 fixedrate mortgage loans meant comparing interest rates, monthly payments, fees, prepayment penalties, and dueonsale 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 fixedrate 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 worksheet on this site should help you ask lenders the right questions and figure out whether an ARM is right for you. Asking lenders to fill out the worksheet is a good way to get the information you need to compare mortgages. What is an ARM?With a fixedrate 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 fixedrate mortgages. This makes the ARM easier on your pocketbook at first than a fixedrate 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 fixedrate 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 tradeoff—you get a lower rate with an ARM in exchange for assuming more risk. Here are some questions you need to consider:
How ARMs work: The basic featuresThe Adjustment Period The Index Lenders base ARM rates on a variety of indexes. Among the most common indexes are the rates on one, three, or fiveyear 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 as an index, 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 fluctuated in the past and where it is published. The Margin Let's say, for example, that you are comparing ARMs offered by two different lenders. Both ARMs are for 30 years with a loan amount of $65,000. (All the examples used in this booklet are based on this amount for a 30year term. Note that the payment amounts shown here do not include items like taxes or insurance.) Both lenders use the oneyear Treasury index. But the first lender uses a 2% margin, and the second lender uses a 3% margin. Here is how that difference in the margin would affect your initial monthly payment.
In comparing ARMs, look at both the index and margin for each program. Some indexes have higher average values, but they are usually used with lower margins. Be sure to discuss the margin with your lender. Consumer CautionsDiscounts 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 oneyear 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
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 because of a low initial rate. You can protect yourself from large increases 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 fixedrate mortgage. While these may offer real benefits, they may also cost more, or add special features, such as negative amortization. InterestRate Caps
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 when an interest rate cap has been holding your interest rate down below the sum of the index plus margin. If a rate cap holds down your interest rate, increases to the index that were not imposed due to the cap may carry over to future rate adjustments. With some ARMs, payments may increase even if the index rate stays the same or declines. To show how carryovers work, the index in the example below increased 3% during the first year. Because this ARM limits rate increases to 2% at any one time, the rate is adjusted by only 2%, to 12% for the second
year. However, the remaining 1% increase in the index carries over to the next time the creditor can adjust rates. So when the creditor adjusts the interest rate for the third year, the rate increases 1%, to 13%, even though there is no change in the index during the second year. 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.
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 yearbased on a 19% interest rate. Payment Caps Let's assume that your rate changes in the first year by 2 percentage points, but your payments can increase by no more than 7.5% in any one year. Here's what your payments would look like:
Many ARMs with payment caps do not have periodic interest rate caps. Negative Amortization Because payment caps limit only the amount of payment increases, and not interestrate 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 7.5% 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. Prepayment and Conversion
The interest rate or upfront 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 informationBefore 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 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 APR, 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 Read information from lendersand ask questionsbefore 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 worksheet on this site is intended to help you compare terms on different loans. Glossary
