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ADJUSTABLE RATE MORTGAGES
Source: Federal Reserve Board
ARM: Adjustable Rate Mortgage;
a mortgage loan subject to changes in interest rates; when rates change,
ARM monthly payments increase or decrease at intervals determined by the
lender; the Change in monthly payment amount, however, is usually subject
to a Cap.
“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 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 ARMs. This booklet
should help. 

WHAT IS AN ARM?
With a fixedrate 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
fixedrate mortgages. This makes the ARM easier on your pocketbook at
first than a fixedrate 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 year’s payments. Moreover, your ARM could be less
expensive over a long period than a fixedrate 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 tradeoff—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
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 oneyear ARM, and the interest rate can
change once every year.
The Index
Most lenders tie ARM interestrate 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 fiveyear 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
Let’s say, for example, that you are comparing ARMs 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 30year term. Note that the payment amounts shown here do not include
taxes, insurance, or similar items.)
Both lenders use the rate on oneyear 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.

Home sale price $ 85,000
Less down payment – 20,000
Mortgage amount $ 65,000
Mortgage term 30 years
FIRST LENDER
Oneyear index = 8%
Margin = 2%
ARM interest rate = 10%
Monthly payment @ 10% = $570.42
SECOND LENDER
Oneyear index = 8%
Margin = 3%
ARM interest rate = 11 %
Monthly payment @ 1 1 % = $619.01
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 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 that the lender’s
“standard” oneyear 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 firstyear monthly payment would be $476.95.
But don’t 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. Let’s see what would happen in the second
year if the rate on your discounted 8% ARM were to rise to the 10% “standard”
rate.
ARM Interest Rate Monthly Payment
1st year (w/discount) @ 8% $476.95
2nd year @ 10 % $568.82
As the example shows, even if the index rate were to stay 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’s 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 reduce this risk.
ARM Interest Rate Monthly Payment
1st year (w/discount) @ 8% $476.95
2nd year @ 12% $665.43
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 fixedrate mortgage. While they
may offer real benefits, these ARMs may also cost more, or may add special
features such as negative amortization.
InterestRate Caps
An interestrate cap places a limit on the amount your interest rate can
increase. Interest caps come in two versions:
• Periodic caps, which limit the interestrate increase from one
adjustment period to the next; and
• Overall caps, which limit the interestrate increase over the
life of the loan.
By law, virtually all ARMs must have an overall cap. Many have a periodic
cap. Let’s suppose you have an ARM with a periodic interestrate
cap of 2%. At the first adjustment, the index rate goes up 3%. The example
shows what happens.
ARM Interest Rate Monthly Payment
1st year @10% $570.42
2nd year @ 13% (without cap) $717.1 2
2nd year @ 12% (with cap) $667.30
Difference in 2nd year between payment with cap and payment without =
$49.82
A drop in interest rates does not always lead to a drop in monthly payments.
In fact, with some ARMs that have interestrate caps, your payment amount
may increase even though the index rate has stayed the same or declined.
This may happen when an interestrate 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.
ARM Interest Rate Monthly Payment
First year @10% $570.42
If index rises 3% . . .
2nd year @ 12% (with 2% rate cap) $667.30
If index stays the same for the 3rd year @ 13% $716.56
Even though the index stays the same in 3rd year, payment goes up $49.26
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 lender’s standard ARM rate (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.
ARM Interest Rate Monthly Payment
1st year @10% $570.42
10th year @ 15% (with cap) $81 3.00
Let’s say that the index rate increases 1% in each of the next
nine 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% 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, 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:
ARM Interest Rate Monthly Payment
1st year @10% $570.42
2nd year @ 12% (without payment cap) $667.30
2nd year @ 12% (with 7 1/2% payment cap) $613. 20
Difference in monthly payment = $54.10
Many ARMs with payment caps do not have periodic interestrate 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
interestrate 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.
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, your 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.
Beginning loan amount = $65,000
Loan amount at end of 1st year = $64,638.72
Negative amortization during 2nd year = $420.90
Loan amount at end of 2nd year = $65,059.62 ($64,638.72 + $420.90) (If
you sold your house at this point, you would owe almost $60 more than
you originally borrowed.)
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 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 may include a clause that lets
you convert the ARM to a fixedrate mortgage at designated times. When
you convert, the new rate is generally set at the current market rate
for fixedrate mortgages.
The interest rate or upfront 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 such as
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. Although
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. So 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 APR, 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.
Ads may play up low initial rates. Get all the facts.
Disclosures From Lenders
Federal law requires the lender to give you information about ARMs, in
most cases before you apply for a loan. The lender also is required to
give you information when you apply for a mortgage. You should get a written
summary of important terms and costs of the loan. Some of these are the
finance charge, the APR, and the payment terms.
Read information from lenders–and ask questions– before
committing yourself.
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 booklet is intended to help you compare terms on different
loans.
GLOSSARY
AdjustableRate Mortgage (ARM)
A mortgage for which 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 (adjustablemortgage loans) or VRMs
(variablerate mortgages).
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 when calculating the APR, it provides consumers with a good basis
for comparing the cost of loans, including 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 dueonsale 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 may 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 fixedrate
loan at some point during the term. Conversion is usually 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
fixedrate 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 interestrate 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. You should ask
your lender how the index for any ARM you are considering has changed
in recent years, and where the index 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 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
One point is equal to 1 percent of the principal amount of your mortgage.
For example, if the mortgage is for $65,000, one point equals $650. Lenders
frequently charge points in both fixedrate and adjustablerate 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.
MORTGAGE CHECKLIST for ARM
Ask your lender to help fill out this checklist.
Mortgage amount
Basic Features for Comparison
Fixedrate annual percentage rate
(the cost of your credit as a yearly rate, including 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?
Interestrate 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 12 months if the index rate:
stays the same
goes up 2%
goes down 2%
What will my monthly payment be after 3 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 that it may run
30 years.
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