«CONSUMER HANDBOOK ON ADJUSTABLE RATE MORTGAGES This booklet was originally prepared by the Federal Reserve Board and the Office of Thrift Supervision ...»
CONSUMER HANDBOOK ON ADJUSTABLE
This booklet was originally prepared by the Federal Reserve Board and the Office of Thrift Supervision in
consultation with the following organizations:
American Bankers Association
America’s Community Bankers
(formerly the National Council of Savings Institutions and the U.S. League of Savings
Institutions) Comptroller of the Currency Consumer Federation of America Credit Union National Association, Inc.
Federal Deposit Insurance Corporation Federal Reserve Board’s Consumer Advisory Council Federal Trade Commission Independent Bankers Association of America Mortgage Bankers Association of America Mortgage Insurance Companies of America National Association of Federal Credit Unions National Association of Home Builders National Association of Realtors National Credit Union Association Office of Special Advisor to the President for Consumer Affairs The Consumer Bankers Association U.S. Department of Housing and Urban Development.
The Federal Reserve Board and the Office of Thrift Supervision prepared this booklet on adjustable rate 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?” 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 betteronce you understand more about ARMs. 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. 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 that 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 the interest rates generally do not increase?
HOW ARMs WORK: THE BASIC FEATURESThe 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 pay 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 institutions. 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 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 with 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 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 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 Some lenders offer initial ARM rates that are lower than the sum of the index and the margin.
Such rates, called discount 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 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 12%.
That is 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.
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 index-rate increase from one adjustment period to the next;
• 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 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 the future rate adjustments.
With some ARMs, payments may increase even if the index rate says 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 the 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.
Let’s say that the index increases 1% in each of the first 10 years. With a 5% overall rate 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% interest 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, a 7 1/2% payment cap, a payment of $100 could increase to no more than $107.50 in the first adjustment, 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 7 1/2% in any one year. Here’s what your payments would look
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 increases. This occurs whenever your monthly 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.