Consumer Handbook on Adjustable Rate Mortgages
Consumer Handbook on Adjustable Rate
Mortgages
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.
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.
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.
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.
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.
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.
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%.
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 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 7½%
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 7½% 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
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 7½% 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
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.
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.
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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