The Federal Reserve Board
and the Office of Thrift Supervision prepared this information on
adjustable-rate mortgages (ARM's). It is designed to help
consumers understand an important and complex mortgage option available
to homebuyers.
Some of the ads you see are
for adjustable rate mortgages (ARM's). These loans may have low rates
for a short time--maybe only for the first year. After that, the rates
may be adjusted on a regular basis. This means that the interest rate
and the amount of the monthly payment may 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 ARM's
put a ceiling on your payment increase or interest-rate increase from
one period to the next. Virtually all types must put a ceiling on 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. ARM's carry risks in
periods of rising interest rates, but they 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 ARM's.
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 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 article explains how
ARM's work and some of the risks and advantages to borrowers that ARM's
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. 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 ARM's 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 the decision about whether
to extend a loan on the basis of your current income and the first
years 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. Its 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 ARM's Work: the Basic Features
The adjustment period
With most ARM's, the
interest rate and monthly payment change every year, every three years,
or every five years. However, some ARM's have more frequent rate and
payment changes. The period between one rate change and the next is
called the adjustment period. 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 indexes 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 as an index,
which gives them more control than using other indexes. 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
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 may differ from one
lender to another, but it is usually constant over the life of the
loan.
Index rate + margin = ARM interest rate Lets say, for example,
that you are comparing ARM's offered by two different lenders. Both
ARMs are for 30 years and have a loan 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 taxes,
insurance, or similar items.)
Both lenders use the rate
on one-year Treasury securities as the 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
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 their standard ARM rates (that is,
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 rates after the discount expires.
Very large discounts are
often arranged by the seller. The seller pays an amount to the lender
so that the lender can give you a lower rate and lower payments early
in the mortgage term. This arrangement is referred to as a seller buy
down. The seller may increase the sales price of the home to cover the
cost of the buy down.
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.
Lets assume that the lenders standard one-year ARM rate (index rate
plus margin) is currently 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 dont forget that with
a discounted ARM, your initial payment will probably remain at $476.95
for only 12 months and that any savings during the discount period may
be made up during the life of the mortgage or may 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. Lets
see what would happen in the second year if the rate on your discounted
8% ARM were to rise to the 10% standard rate.
Thats 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, that may
How Can I Reduce My Risk?
Besides offering 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 they may offer real
benefits, these ARMs may also cost more, or may 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:
An interest-rate cap places a limit on the amount your interest rate can increase. Interest caps come in two versions:
Overall caps, which limit the interest-rate increase over the life of the loan.
Periodic caps, which limit the interest-rate increase from one adjustment period to the next
By law, virtually all ARM's must have an overall cap. Many have a periodic cap.
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
because of 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.
The following example shows
how carryovers work. The index 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
lender can adjust rates. So when the lender 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 lenders
standard ARM rate (the index plus the margin) is higher than the rate
you are paying before that adjustment.
Payment caps
Some ARM's 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 7.5% 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. .
Many ARMs with payment caps do not have periodic interest-rate caps.
Negative amortization
If your ARM includes a
payment cap, be sure to find out about negative amortization.
Negative amortization means that the mortgage balance increases. It
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 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.
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 include 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 dont 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 may include 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.
