Adjustable Rate Mortgages

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?

	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.

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 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%.

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 7% 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 7% in any one year.

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 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.

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.

	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.

                                       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.

American Bankers Association 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 Council of Savings Institutions National Credit Union Administration Office of Special Advisor to the President for Consumer Affairs The Consumer Bankers Association U.S. Department of Housing and Urban Development U.S. League of Savings Institutions