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     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



"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.


     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?



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


     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.



     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 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


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%. 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

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 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

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 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.


     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.


     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


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.


     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

is reported.


     The number of percentage points the lender adds to the

index rate to calculate the ARM interest rate at each


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.


     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

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.


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