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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 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. |
