Consumer Handbook On Adjustable Rate Mortgages

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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



"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

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.



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

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 sizeable 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



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.




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 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. 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.



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

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

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.



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 emphasising
that those rates and payments later could increase substantially. Get all the

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

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.



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


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.

Buy down

With a buy down, 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 buy down. Buy downs can occur in all types of mortgages, not just


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.


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


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.

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.


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. 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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