«Consumer Handbook on Adjustable-Rate Mortgages |i Consumer Handbook on Adjustable-Rate Mortgages Table of contents Mortgage shopping worksheet What ...»
The Federal Reserve Board
Consumer Handbook on
Consumer Handbook on Adjustable-Rate Mortgages
Table of contents
Mortgage shopping worksheet
What is an ARM?
How ARMs work: the basic features
Initial rate and payment
The adjustment period
Types of ARMs
Discounted interest rates
Negative amortization—when you owe more money than you borrowed
Prepayment penalties and conversion
Graduated-payment or stepped-rate loans
Where to get information
Disclosures from lenders
Newspapers and the Internet
Where to go for help
More resources and ordering information
ii | Consumer Handbook on Adjustable-Rate Mortgages This information was prepared by the Board of Governors of the Federal Reserve System and the Office of Thrift Supervision in
consultation with the following organizations:
An adjustable-rate mortgage (ARM) is a loan with an interest rate that changes. ARMs may start with lower monthly payments
than fixed-rate mortgages, but keep in mind the following:
Your monthly payments could change. They could go up— sometimes by a lot—even if interest rates don’t go up. See page 20.
Your payments may not go down much, or at all—even if interest rates go down. See page 11.
You could end up owing more money than you borrowed— even if you make all your payments on time. See page 22.
If you want to pay off your ARM early to avoid higher payments, you might pay a penalty. See page 24.
You need to compare the features of ARMs to find the one that best fits your needs. The Mortgage Shopping Worksheet on page 2 can help you get started.
Mortgage shopping worksheet 2| Consumer Handbook on Adjustable-Rate Mortgages Ask your lender or broker to help you fill out this worksheet.
Name of lender or broker and contact information Mortgage amount Loan term (e.g., 15 years, 30 years) Loan description (e.g., fixed rate, 3/1 ARM, payment-option ARM, interest-only ARM) Basic Features for Comparison Fixed-rate mortgage interest rate and annual percentage rate (APR) (For graduated-payment or stepped-rate mortgages, use the ARM columns.) ARM initial interest rate and APR How long does the initial rate apply?
What will the interest rate be after the initial period?
ARM features How often can the interest rate adjust?
What is the index and what is the current rate? (See chart on page 8.) What is the margin for this loan?
Interest-rate caps What is the periodic interest-rate cap?
What is the lifetime interest-rate cap? How high could the rate go?
How low could the interest rate go on this loan?
What is the payment cap?
Can this loan have negative amortization (that is, increase in size)?
What is the limit to how much the balance can grow before the loan will be recalculated?
Is there a prepayment penalty if I pay off this mortgage early?
How long does that penalty last? How much is it?
Is there a balloon payment on this mortgage?
If so, what is the estimated amount and when would it be due?
What are the estimated origination fees and charges for this loan?
What is an ARM?
An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. Most importantly, with a fixed-rate mortgage, the interest rate stays the same during the life of the loan. With an ARM, the interest rate changes periodically, usually in relation to an index, and payments may go up or down accordingly.
To compare two ARMs, or to compare an ARM with a fixed-rate mortgage, you need to know about indexes, margins, discounts, caps on rates and payments, negative amortization, payment options, and recasting (recalculating) your loan. You need to consider the maximum amount your monthly payment could increase. Most importantly, you need to know what might happen to your monthly mortgage payment in relation to your future ability to afford higher payments.
Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. At first, this makes the ARM easier on your pocketbook than would be a fixed-rate mortgage for the same loan amount. 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.
Is my income enough—or 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.) Do I plan to make any additional payments or pay the loan off early?
Lenders and Brokers Mortgage loans are offered by many kinds of lenders—such as banks, mortgage companies, and credit unions. You can also get a loan through a mortgage broker. Brokers “arrange” loans; in other words, they find a lender for you. Brokers generally take your application and contact several lenders, but keep in mind that brokers are not required to find the best deal for you unless they have contracted with you to act as your agent.
6| Consumer Handbook on Adjustable-Rate Mortgages
How ARMs work:the basic featuresInitial rate and payment
The initial rate and payment amount on an ARM will remain in effect for a limited period—ranging from just 1 month to 5 years or more. For some ARMs, the initial rate and payment can vary greatly from the rates and payments later in the loan term. Even if interest rates are stable, your rates and payments could change a lot. If lenders or brokers quote the initial rate and payment on a loan, ask them for the annual percentage rate (APR). If the APR is significantly higher than the initial rate, then it is likely that your rate and payments will be a lot higher when the loan adjusts, even if general interest rates remain the same.
The adjustment period
Loan Descriptions Lenders must give you written information on each type of ARM loan you are interested in. The information must include the terms and conditions for each loan, including information about the index and margin, how your rate will be calculated, how often your rate can change, limits on changes (or caps), an example of how high your monthly payment might go, and other ARM features such as negative amortization.
The interest rate on an ARM is made up of two parts: the index and the margin. The index is a measure of interest rates generally, and the margin is an extra amount that the lender adds.
Your payments will be affected by any caps, or limits, on how high or low your rate can go. If the index rate moves up, so does your interest 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 could go down. Not all ARMs adjust downward, however—be sure to read the information for the loan you are considering.
Lenders base ARM rates on a variety of indexes. Among the most common indexes are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indexes. You should ask what index will be used, how it has 8| Consumer Handbook on Adjustable-Rate Mortgages fluctuated in the past, and where it is published—you can find a lot of this information in major newspapers and on the Internet.
To help you get an idea of how to compare different indexes, the following chart shows a few common indexes over an 11-year period (1996–2008). As you can see, some index rates tend to be higher than others, and some change more often. But if a lender bases interest-rate adjustments on the average value of an index over time, your interest rate would not change as dramatically.
constant over the life of the loan. The fully indexed rate is equal to the margin plus the index. If the initial rate on the loan is less than the fully indexed rate, it is called a discounted index rate. For example, if the lender uses an index that currently is 4% and adds a 3% margin, the fully indexed rate would be
If the index on this loan rose to 5%, the fully indexed rate would be 8% (5% + 3%). If the index fell to 2%, the fully indexed rate would be 5% (2% + 3%).
Some lenders base the amount of the margin on your credit record— the better your credit, the lower the margin they add—and the lower the interest you will have to pay on your mortgage. In comparing ARMs, look at both the index and margin for each program.
No-Doc/Low-Doc Loans When you apply for a loan, lenders usually require documents to prove that your income is high enough to repay the loan. For example, a lender might ask to see copies of your most recent pay stubs, income tax filings, and bank account statements. In a “no-doc” or “low-doc” loan, the lender doesn’t require you to bring proof of your income, but you will usually have to pay a higher interest rate or extra fees to get the loan. Lenders generally charge more for no-doc/low-doc loans.
10 | Consumer Handbook on Adjustable-Rate Mortgages Interest-rate caps
Periodic adjustment caps Let’s suppose you have an ARM with a periodic adjustment interest-rate cap of 2%. However, at the first adjustment, the index rate has risen 3%. The following example shows what happens.
In this example, because of the cap on your loan, your monthly payment in year 2 is $138.70 per month lower than it would be without the cap, saving you $1,664.40 over the year.
Some ARMs allow a larger rate change at the first adjustment and then apply a periodic adjustment cap to all future adjustments.
A drop in interest rates does not always lead to a drop in your monthly payments. With some ARMs that have interest-rate caps, the cap may hold your rate and payment below what it would have been if the change in the index rate had been fully applied. The increase in the interest that was not imposed because of the rate cap might carry over to future rate adjustments. This is called carryover. So, at the next adjustment date, your payment might increase even though the index rate has stayed the same or declined.
The following example shows how carryovers work. Suppose the index on your ARM increased 3% during the first year.
12 | Consumer Handbook on Adjustable-Rate Mortgages Because this ARM limits rate increases to 2% at any one time, the rate is adjusted by only 2%, to 8% 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, even if there has been no change in the index during the second year, the rate still increases by 1%, to 9%.
In general, the rate on your loan can go up at any scheduled adjustment date when the lender’s standard ARM rate (the index plus the margin) is higher than the rate you are paying before that adjustment.
Payment caps In addition to interest-rate caps, many ARMs—including payment-option ARMs (discussed on page 16)—limit, or cap, the amount your monthly payment may increase at the time of each adjustment. For example, if your loan has a payment cap of 7½%, your monthly payment won’t increase more than 7½% over your previous payment, even if interest rates rise more. For example, if your monthly payment in year 1 of your mortgage was $1,000, it could only go up to $1,075 in year 2 (7½% of $1,000 is an additional $75). Any interest you don’t pay because of the payment cap will be added to the balance of your loan. A payment cap can limit the increase to your monthly payments but also can add to the amount you owe on the loan. (This is called negative amortization, a term explained on page 22.) Let’s assume that your rate changes in the first year by 2 percentage points, but your payments can increase no more than 7½% in any 1 year. The following graph shows what your monthly payments would look like.
14 | Consumer Handbook on Adjustable-Rate Mortgages While your monthly payment will be only $1,289.03 for the second year, the difference of $172.69 each month will be added to the balance of your loan and will lead to negative amortization.
Types of ARMs Hybrid ARMs Hybrid ARMs often are advertised as 3/1 or 5/1 ARMs—you might also see ads for 7/1 or 10/1 ARMs. These loans are a mix—or a hybrid—of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first few years of these loans—for example, for 5 years in a 5/1 ARM. After that, the rate may adjust annually (the 1 in the 5/1 example), until the loan is
paid off. In the case of 3/1 or 5/1 ARMs:
the first number tells you how long the fixed interest-rate period will be, and the second number tells you how often the rate will adjust after the initial period.
You may also see ads for 2/28 or 3/27 ARMs—the first number tells you how many years the fixed interest-rate period will be, and the second number tells you the number of years the rates on the loan will be adjustable. Some 2/28 and 3/27 mortgages adjust every 6 months, not annually.
Interest-only (I-O) ARMs An interest-only (I-O) ARM payment plan allows you to pay only the interest for a specified number of years, typically for 3 to 10 years. This allows you to have smaller monthly payments for a period. After that, your monthly payment will increase—even if interest rates stay the same—because you must start paying back the principal as well as the interest each month.