Adjustable Rate Mortgages FAQ’s
Updated for .
Everything you ever wanted to know about adjustable rate mortgages
but were afraid to ask.
Adjustable Rate Mortgages: “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.
Adjustable Rate Mortgages: “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.
Adjustable Rate Mortgages: “Is an adjustable rate mortgage the right type of loan for me?”
That depends on your financial situation and the terms of the adjustable rate mortgage.
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 ARMs.
This webpage should help. Mortgages have changed, and so have the
questions that consumers need to ask and have 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 adjustable rate mortgage 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 webpage 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 adjustable rate mortgage terms are defined in a glossary.
And a checklist at the end of the webpage
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 adjustable rate mortgage?
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 adjustable rate mortgage 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 adjustable rate mortgage 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 adjustable rate mortgage, 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 indexes 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 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 adjustable rate mortgage, 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.
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 with a loan amount of
$65,000. (All the examples used in this webpage 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.
FIRST LENDER SECOND LENDER |
||||||||
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 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 adjustable rate mortgage
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% adjustable rate mortgage.
| ARM Interest Rate |
Monthly Payment |
| First year (w/discount) 8% |
$476.95 |
| 2nd year @ 10 % | $568.82 |
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%.
| adjustable rate mortgage Interest Rate |
Monthly Payment |
| First year (w/discount) 8% |
$476.95 |
| 2nd year @ 12% |
$665.43 |
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, 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 adjustable rate mortgage with a
periodic interest rate cap of 2%. At the first adjustment, the index
rate goes up 3%. The example shows what happens.
| ARM Interest Rate | Monthly Payment |
| First year @ 10% | $570.42 |
| 2nd year @ 13% (without cap) | $717.12 |
| 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 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 future
rate adjustments.
With some ARMs, payments may increase even if the
index rate stays 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 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.
| adjustable rate mortgage 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 the 3rd year, payment goes up $49.26. |
|
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.
| ARM Interest Rate | Monthly Payment |
| First year @ 10% | $570.42 |
| 10th year @ 15% (with cap) | $813.00 |
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% 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 71/2% 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 71/2%
in any one year. Here’s what your payments would look like:
| ARM Interest Rate | Monthly Payment |
| First year @ 10% | $570.42 |
| 2nd year @ 12% (without payment cap) | $667.30 |
| 2nd year @ 12% (with 71/2% payment cap) | $613.20 |
| Difference in monthly payment = $54.10 | |
Many ARMs with payment caps do not have periodic interest rate
caps.
Negative Amortization
If your adjustable rate mortgage contains a payment cap, be sure to find out about
“negative amortization.” Negative amortization means the
mortgage balance increases. 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 71/2% 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.
|
Beginning loan amount = $65,000 Loan amount @ end of first year = Negative amortization during 2nd year = Loan amount @ end of 2nd year = (If you sold your house at this point, you |
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 adjustable rate mortgage, 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 adjustable rate mortgage. 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. 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 adjustable rate mortgage
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 is intended to help
you compare terms on different loans.
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).
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 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 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.
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 adjustable rate mortgage 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.
In an adjustable rate mortgage 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.
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
(1987-97). 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 adjustable rate mortgage you are considering has changed in recent years, and
where it is reported.
[line graph omitted]
The number of percentage points the lender adds to the index rate
to calculate the adjustable rate mortgage interest rate at each adjustment.
Amortization means that monthly payments are large enough to pay
the interest and reduce the principle 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
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.
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