# CONSUMER HANDBOOK ON ADJUSTABLE RATE MORTGAGES

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3 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 the 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. 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 pay 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 institutions. 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 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. 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 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.)

4 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. Home sale price: \$85,000 Less down payment - 20,000 Mortgage amount: \$65,000 Mortgage term: 30 years First Lender One-year index = 8% Margin = 2% ARM interest rate = 10% Monthly 10% \$ Second Lender One-year index = 8% Margin = 3% ARM interest rate = 11% Monthly 11% \$ 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 discount 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 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 \$

6 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. ARM Interest Rate Monthly Payment First 10% \$ nd 13% (without cap) \$ nd 12% (with cap) \$ Difference in 2 nd 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 the future rate adjustments. With some ARMs, payments may increase even if the index rate says 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 the 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. ARM Interest Rate Monthly Payment First 10% \$ If index rises 3% 2 nd 12% (with 2% rate cap) \$ If the index remains the same for the 3 rd \$ Even though index stays the same in the 3 rd year, payment goes up \$49.26

11 shows a few common indexes over a ten-year period ( ). 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 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.

12 MORTGAGE CHECKLIST Ask your lender to help fill out this checklist Mortgage A 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 Amount 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. Mortgage B

### CONSUMER HANDBOOK ON ADJUSTABLE RATE MORTGAGES

CONSUMER HANDBOOK ON ADJUSTABLE RATE MORTGAGES Federal Reserve Board Office of Thrift Supervision This booklet was originally prepared in consultation with the following organizations: American Bankers

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