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
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 better once
you understand more about adjustable-rate mortgages. 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
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 on page
19. 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 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 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 ARM, and the interest
rate can change once every year.
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
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.
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
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.
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
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 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 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.
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
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%. 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
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
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.
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
Many ARMs with payment caps do not have periodic interest
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 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, 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.
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
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
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
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.
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
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
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).
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.
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
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
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.
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
The number of percentage points the lender adds to the
index rate to calculate the ARM interest rate at each
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.
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.
Ask your lender to help fill
out this checklist. Mortgage A Mortgage B
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.