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The ARM Handbook

 

 
 
The Federal Reserve Board
 
Consumer Handbook on
ADJUSTABLE-RATE MORTGAGES
Table of contents
What is an ARM?
....................................................................................................... 3
Mortgage shopping worksheet
.................................................................................................................. 4
How ARMs work: the basic features
Initial rate and payment .................................................................................................................... 5
The adjustment period ........................................................................................................................ 5
The index ......................................................................................................................... 5
The margin ....................................................................................................................... 6
Interest-rate caps ......................................................................................................................... 6
Payment caps ......................................................................................................................... 8
..................................................................................................................... 5
Types of ARMs
Hybrid ARMs ......................................................................................................................................... 9
Interest-only ARMs ............................................................................................................................... 9
Payment-option ARMs .......................................................................................................................... 9
................................................................................................................................
Consumer cautions
Discounted interest rates ....................................................................................................................... 10
Payment shock .................................................................................................................................... 10
Negative amortization.when you owe more
money than you borrowed ..................................................................................................................... 11
Prepayment penalties and conversion ................................................................................................... 12
Graduated-payment or stepped-rate loans ............................................................................................ 13
................................................................................................................................... 10
Where to get information
Disclosures from lenders ....................................................................................................................... 13
Newspapers and the Internet ............................................................................................................... 13
Advertisements .................................................................................................................................... 13
........................................................................................................................... 13
Glossary
.................................................................................................................................................... 14
Where to go for help
................................................................................................................................. 16
More resources and ordering information
................................................................................................ 17
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This information was prepared by the Board of Governors of the Federal Reserve System and the Office of Thrift
Supervision in consultation with the following organizations:
AARP
American Association of Residential Mortgage Regulators
America’s Community Bankers
Center for Responsible Lending
Conference of State Bank Supervisors
Consumer Federation of America
Consumer Mortgage Coalition
Consumers Union
Credit Union National Association
Federal Deposit Insurance Corporation
Federal Reserve Board’s Consumer Advisory Council
Federal Trade Commission
Financial Services Roundtable
Independent Community Bankers Association
Mortgage Bankers Association
Mortgage Insurance Companies of America
National Association of Federal Credit Unions
National Association of Home Builders
National Association of Mortgage Brokers
National Association of Realtors
National Community Reinvestment Coalition
National Consumer Law Center
National Credit Union Administration
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The Federal Reserve Board
Consumer Handbook on
ADJUSTABLE-RATE MORTGAGES
This handbook gives you an over­view of ARMs, explains how
ARMs work, and discusses some of the issues that you might face
as a borrower. It includes:
 ways to reduce the risks associated with ARMs;
 pointers about advertising and other sources of information,
such as lenders and other trusted advisers;
 a glossary of important ARM terms; and
 a worksheet that can help you ask the right questions and
figure out whether an ARM is right for you. (Ask lenders to help
you fill out the worksheet so you can get the information you
need to compare mortgages.)
An adjustable-rate mortgage (ARM) is a loan with an interest
rate that changes. ARMs may start with lower monthly payments
than fixed-rate mortgages, but keep in mind the following:
 Yourmonthlypayments couldchange.They couldgoup.sometimesbyalot.evenif interestratesdon’tgoup.Seepage10.
 Your payments may not go down much, or at all.even if interest rates go down. See page 7.
 You could end up owing moremoney than you borrowed.even if you make all your payments on time. See page 11.
 If you want to pay off your ARM early to avoid higher payments, you might pay a penalty. See page 12.
You need to compare the features of ARMs to find the one that best fits your needs. The Mortgage Shopping
Worksheet on page 4 can help you get started.
What is an ARM?
An adjustable-rate mortgage differs from a fixed-rate mortgage in many ways. Most importantly, with a fixed-rate
mortgage, the interest rate stays the same during the life of the loan. With an ARM, the interest rate changes periodically,
usually in relation to an index, and payments may go up or down accordingly.
To compare two ARMs, or to compare an ARM with a fixed-rate mortgage, you need to know about indexes, margins,
discounts, caps on rates and payments, negative amortization, payment options, and recasting (recalculating) your
loan. You need to consider the maximum amount your monthly payment could increase. Most importantly, you need
to know what might happen to your monthly mortgage payment in relation to your future ability to afford higher payments.
Lenders generally charge lower initial interest rates for ARMs than for fixed-rate mortgages. At first, thismakes the ARM
easier on your pocketbook than would be a fixed-rate mortgage for the same loan amount. 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 initial rate with an ARM in exchange for assuming more risk over
the long run. Here are some questions you need to consider:
 Is my income enough.or 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.)
 Do I plan to make any additional payments or pay the loan off early?
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Mortgage Shopping Worksheet
Ask your lender or broker to help you fill out this worksheet.
Fixed-Rate ARM 1 ARM 2 ARM 3
Mortgage
Name of lender or broker and contact information
Mortgage amount
Loan term (e.g., 15 years, 30 years)
Loan description (e.g., fixed rate, 3/1 ARM, payment-option
ARM, interest-only ARM)
Basic Features for Comparison
Fixed-rate mortgage interest rate and annual percentage rate
(APR) (For graduated-payment or stepped-rate mortgages,
use the ARM columns.)
ARM initial interest rate and APR
How long does the initial rate apply?
What will the interest rate be after the initial period?
ARM features
How often can the interest rate adjust?
What is the index and what is the current rate?
(See chart on page 6.)
What is the margin for this loan?
Interest-rate caps
What is the periodic interest-rate cap?
What is the lifetime interest-rate cap? How high could the
rate go?
How low could the interest rate go on this loan?
What is the payment cap?
Can this loan have negative amortization (that is, increase in size)?
What is the limit to how much the balance can grow before the loan
will be recalculated?
Is there a prepayment penalty if I pay off this mortgage early?
How long does that penalty last? How much is it?
Is there a balloon payment on this mortgage?
If so, what is the estimated amount and when would it be due?
What are the estimated origination fees and charges for this loan?
Monthly Payment Amounts
What will the monthly payments be for the first year of the loan?
Does this include taxes and insurance? Condo or homeowner’s
association fees? If not, what are the estimates for these amounts?
What will my monthly payment be after 12 months if the index rate.
.stays the same?
.goes up 2%?
.goes down 2%?
What is the
1 year?
What is the
3 years?
What is the
5 years?
most my minimum monthly payment could be aftermost my minimum monthly payment could be aftermost my minimum monthly payment could be after
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Lenders and Brokers
Mortgage loans are offered bymany kinds of lenders.such as banks,mortgage companies, and credit unions.
You can also get a loan through a mortgage broker. Brokers .arrange. loans; in other words, they find a lender
for you. Brokers generally take your application and contact several lenders, but keep in mind that brokers are
not required to find the best deal for you unless they have contracted with you to act as your agent.
How ARMs work: the basic features
Initial rate and payment
The initial rate and payment amount on an ARM will remain in effect for a limited period.ranging from just 1 month
to 5 years or more. For some ARMs, the initial rate and payment can vary greatly from the rates and payments later in
the loan term. Even if interest rates are stable, your rates and payments could change a lot. If lenders or brokers quote
the initial rate and payment on a loan, ask them for the annual percentage rate (APR). If the APR is significantly higher
than the initial rate, then it is likely that your rate and payments will be a lot higher when the loan adjusts, even if general
interest rates remain the same.
The adjustment period
With most ARMs, the interest rate and monthly payment change every month, quarter, year, 3 years, or 5 years. The
period between rate changes is called the
is called a 1-year ARM, and the interest rate and payment can change once every year; a loan with a 3-year adjustment
period is called a 3-year ARM.
adjustment period. For example, a loan with an adjustment period of 1 year
Loan Descriptions
Lenders must give you written information on each type of ARM loan you are interested in. The information
must include the terms and conditions for each loan, including information about the index and margin, how
your rate will be calculated, how often your rate can change, limits on changes (or caps), an example of how
high your monthly payment might go, and other ARM features such as negative amortization.
The index
The interest rate on an ARM is made up of two parts: the index and the margin. The index is a measure of interest
rates generally, and the margin is an extra amount that the lender adds. Your payments will be affected by any caps,
or limits, on how high or low your rate can go. If the index rate moves up, so does your interest 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 could go down. Not all ARMs adjust downward, however.be sure to read the information for the loan
you are considering.
Lenders base ARM rates on a variety of indexes. Among the most common indexes are the rates on 1-year
constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate
(LIBOR). A few lenders use their own cost of funds as an index, rather than using other indexes. You should ask what
index will be used, how it has fluctuated in the past, and where it is published.you can find a lot of this information
in major newspapers and on the Internet.
To help you get an idea of how to compare different indexes, the following chart shows a few common indexes over
an 11-year period (1996.2008). As you can see, some index rates tend to be higher than others, and some change more
often. But if a lender bases interest-rate adjustments on the average value of an index over time, your interest rate would
not change as dramatically.
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The margin
To set the interest rate on an ARM, lenders add a few percentage points to the index rate, called the
amount of the margin may differ from one lender to another, but it is usually constant over the life of the loan. The
indexed rate
called a
the fully indexed rate would be
margin. Thefullyis equal to the margin plus the index. If the initial rate on the loan is less than the fully indexed rate, it isdiscounted index rate. For example, if the lender uses an index that currently is 4% and adds a 3% margin,
Index 4%
+ Margin 3%
______________________ _____
Fully indexed rate 7%
If the index on this loan rose to 5%, the fully indexed rate would be 8% (5% + 3%). If the index fell to 2%, the fully
indexed rate would be 5% (2% + 3%).
Some lenders base the amount of the margin on your credit record. the better your credit, the lower the margin
they add.and the lower the interest you will have to pay on your mortgage. In comparing ARMs, look at both the index
and margin for each program.
No-Doc/Low-Doc Loans
When you apply for a loan, lenders usually require documents to prove that your income is high enough to
repay the loan. For example, a lender might ask to see copies of your most recent pay stubs, income tax
filings, and bank account statements. In a .no-doc. or .low-doc. loan, the lender doesn’t require you to bring
proof of your income, but you will usually have to pay a higher interest rate or extra fees to get the loan.
Lenders generally charge more for no-doc/low-doc loans.
Interest-rate caps
An interest-rate cap places a limit on the amount your interest rate can increase. Interest caps come in two
versions:

period to the next after the first adjustment, and

a lifetime cap.
A periodic adjustment cap, which limits the amount the interest rate can adjust up or down from one adjustmentA lifetime cap, which limits the interest-rate increase over the life of the loan. By law, virtually all ARMs must have
Periodic adjustment caps
Let’s suppose you have an ARM with a periodic adjustment interest-rate cap of 2%. However, at the first adjustment,
the index rate has risen 3%. The following example shows what happens.
Selected Index Rates for ARMs
over an 11-Year Period
1998 2000 2002 2004 2006 2008
8%
6
4
2
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1-Year London Interbank
Offered Rate (LIBOR)
11th District Cost
of Funds Index (COFI)
1-Year
Constant-Maturity
Treasury (CMT)
Securities
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Examples in This Handbook
All examples in this handbook are based on a $200,000 loan amount and a 30-year term. Payment amounts
in the examples do not include taxes, insurance, condominium or homeowner association fees, or similar
items. These amounts can be a significant part of your monthly payment.
In this example, because of the cap on your loan, your monthly payment in year 2 is $138.70 per month lower than
it would be without the cap, saving you $1,664.40 over the year.
Some ARMs allow a larger rate change at the first adjustment and then apply a periodic adjustment cap to all future
adjustments.
A drop in interest rates does not always lead to a drop in your monthly payments. With some ARMs that have
interest-rate caps, the cap may hold your rate and payment below what it would have been if the change in the index
rate had been fully applied. The increase in the interest that was not imposed because of the rate cap might carry over
to future rate adjustments. This is called
though the index rate has stayed the same or declined.
The following example shows how carryovers work. Suppose the index on your ARM 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 8% for the second
year. However, the remaining 1% increase in the index carries over to the next time the lender can adjust rates. So, when
the lender adjusts the interest rate for the third year, even if there has been no change in the index during the second
year, the rate still increase by 1%, to 9%.
In general, the rate on your loan can go up at any scheduled adjustment date when the lender’s standard ARM rate
(the index plus the margin) is higher than the rate you are paying before that adjustment.
carryover. So at the next adjustment date, your payment might increase even
1st year’s monthly
payment at 6%
2nd year’s monthly
payment at 9%
(without cap)
2nd year’s monthly
payment at 8%
(with cap)
Difference in 2nd year between payment with cap and
payment without = $138.70 per month
$1,000 $1,200 $1,400 $1,600
$1,199.10
$1,600.42
$1,461.72
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$1,000 $1,200 $1,400 $1,600
$1,199.10
$1,461.72
$1,597.84
1st year at 6%
If index rises 3%,
to 9%, 2nd year with
2% rate cap at 8%
If index stays the
same for the 3rd year,
at 9%
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$500 $1,000 $1,500 $2,000 $2,500
1st year at 6%
10th year at 12%
(with lifetime cap)
10th year at 15%
(without lifetime cap)
$1,199.10
$1,998.84
$2,409.11
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Lifetime caps
The next example shows how a lifetime rate cap would affect your loan. Let’s say that your ARM starts out with a
6% rate and the loan has a 6% lifetime cap.that is, the rate can never exceed 12%. Suppose the index rate increases
1% in each of the next 9 years. With a 6% overall cap, your payment would never exceed $1,998.84.compared with
the $2,409.11 that it would have reached in the tenth year without a cap.
Payment caps
In addition to interest-rate caps, many ARMs.including payment-option ARMs (discussed on page 9).limit, or
cap, the amount your monthly payment may increase at the time of each adjustment. For example, if your loan has
a payment cap of 7½%, your monthly payment won’t increase more than 7½% over your previous payment, even if
interest rates rise more. For example, if your monthly payment in year 1 of your mortgage was $1,000, it could only
go up to $1,075 in year 2 (7½% of $1,000 is an additional $75). Any interest you don’t pay because of the payment
cap will be added to the balance of your loan. A payment cap can limit the increase to your monthly payments but also
can add to the amount you owe on the loan. (This is called
Let’s assume that your rate changes in the first year by 2 percentage points, but your payments can increase no
more than 7½% in any 1 year. The following graph shows what your monthly payments would look like.
While your monthly payment will be only $1,289.03 for the second year, the difference of $172.69 each month will
be added to the balance of your loan and will lead to negative amortization.
Some ARMs with payment caps do not have periodic interest-rate caps. In addition, as explained below, most
payment-option ARMs have a built-in recalculation period, usually every 5 years. At that point, your payment will be
recalculated (lenders use the term
are at the end of year 5, your payment will be recalculated for the remaining 25 years. The payment cap does not apply
to this adjustment. If your loan balance has increased, or if interest rates have risen faster than your payments, your
payments could go up a lot.
negative amortization, a term explained on page 11.)recast) based on the remaining term of the loan. If you have a 30-year loan and you
1st year at 6%
2nd year at 8%
(with 7½% payment
cap)
2nd year at 8%
(without payment
cap)
Difference in monthly payment = $172.69
$1,000 $1,200 $1,400 $1,600
$1,199.10
$1,289.03
$1,461.72
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Types of ARMs
Hybrid ARMs
Hybrid ARMs often are advertised as 3/1 or 5/1 ARMs.you might also see ads for 7/1 or 10/1 ARMs. These loans
are a mix.or a hybrid.of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first few years
of these loans.for example, for 5 years in a 5/1 ARM. After that, the rate may adjust annually (the 1 in the 5/1 example),
until the loan is paid off. In the case of 3/1 or 5/1 ARMs:
 the first number tells you how long the fixed interest-rate period will be, and
 the second number tells you how often the rate will adjust after the initial period.
You may also see ads for 2/28 or 3/27 ARMs.the first number tells you how many years the fixed interest-rate period
will be, and the second number tells you the number of years the rates on the loan will be adjustable. Some 2/28 and 3/27
mortgages adjust every 6 months, not annually.
Interest-only (I-O) ARMs
An interest-only (I-O) ARM payment plan allows you to
for3 to 10years.This allows you tohavesmaller monthly paymentsforaperiod.After that,yourmonthly payment will increase.
even if interest rates stay the same.because you must start paying back the principal as well as the interest each month.
For some I-O loans, the interest rate adjusts during the I-O period as well.
For example, if you take out a 30-year mortgage loan with a 5-year I-O payment period, you can pay only interest
for 5 years and then you must pay both the principal and interest over the next 25 years. Because you begin to pay
back the principal, your payments increase after year 5, even if the rate stays the same. Keep in mind that the longer
the I-O period, the higher your monthly payments will be after the I-O period ends.
pay only the interest for a specified number of years,typically
Payment-option ARMs
A payment-option ARM is an adjustable-rate mortgage that allows you to choose among several payment options
each month. The options typically include the following:

payments are based on a set loan term, such as a 15-, 30-, or 40-year payment schedule.

you make your payments.

amount you owe on your mortgage. If you choose this option, the amount of any interest you do not pay will be added
to the principal of the loan,
a traditional payment of principal and interest, which reduces the amount you owe on your mortgage. Thesean interest-only payment, which pays the interest but does not reduce the amount you owe on your mortgage asaminimum (or limited) payment that may be less than the amount of interest due thatmonth andmay not reduce theincreasing the amount you owe and your future monthly payments, and increasing the
$800 $1,000 $1,200 $1,400 $1,600
Monthly interest-only
payments in year 1 at 6%
Monthly principal and
interest payments in
year 6 at 6%
Monthly principal and
interest payments in
year 6 at 8%
$1,000.00
$1,228.60
$1,543.63
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amount of interest you will pay over the life of the loan. In addition, if you pay only the minimum payment in the last few
years of the loan, you may owe a larger payment at the end of the loan term, called a
The interest rate on a payment-option ARM is typically very low for the first few months (for example, 2% for the first
1 to 3 months). After that, the interest rate usually rises to a rate closer to that of other mortgage loans. Your payments
during the first year are based on the initial low rate, meaning that if you only make the minimum payment each month,
it will not reduce the amount you owe and it may not cover the interest due. The unpaid interest is added to the amount
you owe on the mortgage, and your loan balance increases. This is called
after making many payments, you could owe more than you did at the beginning of the loan. Also, as interest rates go
up, your payments are likely to go up.
Payment-option ARMs have a built-in recalculation period, usually every 5 years. At this point, your payment will be
recalculated (or .recast.) based on the remaining term of the loan. If you have a 30-year loan and you are at the end
of year 5, your payment will be recalculated for the remaining 25 years. If your loan balance has increased because you
have made only minimum payments, or if interest rates have risen faster than your payments, your payments will
increase each time your loan is recast. At each recast, your new minimum payment will be a fully amortizing payment
and any payment cap will not apply. This means that your monthly payment can increase a lot at each recast.
Lenders may recalculate your loan payments before the recast period if the amount of principal you owe grows
beyond a set limit, say 110% or 125% of your original mortgage amount. For example, suppose you made only minimum
payments on your $200,000 mortgage and had any unpaid interest added to your balance. If the balance grew to
$250,000 (125% of $200,000), your lender would recalculate your payments so that you would pay off the loan over the
remaining term. It is likely that your payments would go up substantially.
More information on interest-only and payment-option ARMs is available in a Federal Reserve Board brochure,
balloon payment.negative amortization. This means that even
Interest-Only Mortgage Payments and Payment-Option ARMs.Are They for You?
www.federalreserve.gov/consumerinfo/mortgages.htm).
(available online at
Consumer cautions
Discounted interest rates
Many lenders offer more than one type of ARM. Some lenders offer an ARM with an initial rate that is lower than their
fully indexed ARM rate (that is, lower than the sum of the index plus the margin). Such rates.called discounted rates,
start rates, or teaser rates.are often combined with large initial loan fees, sometimes called
rates after the initial discounted rate expires.
Your lender or broker may offer you a choice of loans that may include .discount points. or a .discount fee.. You
may choose to pay these points or fees in return for a lower interest rate. But keep in mind that the lower interest rate
may only last until the first adjustment.
If a lender offers you a loan with a discount rate, don’t assume that means that the loan is a good one for you. You
should carefully consider whether you will be able to afford higher payments in later years when the discount expires
and the rate is adjusted.
Here is an example of how a discounted initial rate might work. Let’s assume that the lender’s fully indexed 1-year
ARM rate (index rate plus margin) is currently 6%; the monthly payment for the first year would be $1,199.10. But your
lender is offering an ARM with a discounted initial rate of 4% for the first year. With the 4% rate, your first-year’s monthly
payment would be $954.83.
With a discounted ARM, your initial payment will probably remain at $954.83 for only a limited time.and any savings
during the discount period may be offset by higher payments over the remaining life of the mortgage. If you are
considering a discount ARM, be sure to compare future payments with those for a fully indexed ARM. In fact, if you buy
a home or refinance using a deeply discounted initial rate, you run the risk of payment shock, negative amortization,
or prepayment penalties or conversion fees.
points, and with higher
Payment shock
Payment shock may occur if your mortgage payment rises sharply at a rate adjustment. Let’s see what would
happen in the second year if the rate on your discounted 4% ARM were to rise to the 6% fully indexed rate.
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As the example shows, even if the index rate were to stay the same, your monthly payment would go up from $954.83
to $1,192.63 in the second year.
Suppose that the index rate increases 1% in 1 year and the ARM rate rises to 7%. Your payment in the second year
would be $1,320.59.
That’s an increase of $365.76 in your monthly payment. You can see what might happen if you choose an ARM
because of a low initial rate without considering whether you will be able to afford future payments.
If you have an interest-only ARM, payment shock can also occur when the interest-only period ends. Or, if you have
a payment-option ARM, payment shock can happen when the loan is recast.
The following example compares several different loans over the first 7 years of their terms; the payments shown
are for years 1, 6, and 7 of the mortgage, assuming you make interest-only payments or minimum payments. The main
point is that, depending on the terms and conditions of your mortgage and changes in interest rates, ARM payments
can change quite a bit over the life of the loan.so while you could save money in the first few years of an ARM, you
could also face much higher payments in the future.
Negative amortization.When you owe more money than you borrowed
Negative amortization means that the amount you owe increases even when you make all your required payments
on time. It occurs whenever your monthly mortgage payments are not large enough to pay all of the interest due on your
mortgage.meaning the unpaid interest is added to the principal on your mortgage and you will owe more than you
originally borrowed. This can happen because you are making only minimum payments on a payment-option mortgage
or because your loan has a payment cap.
Year 1 $1,199.10
Year 6
Year 7
Year 1 $954.83
Year 6 $1,165.51
Year 7 $1,389.51
Year 1 $666.68
Year 6 $1,288.60
Year 7 $1,536.29
Year 1 $739.24
Year 6 $1,603.10
Year 7 $1,708.22
30-year
fixed
5/1 ARM
5/1 I-O
ARM
Paymentoption
mortgage
$954.83
$1,192.63
$1,320.59
$800 $1,000 $1,200 $1,400
Year 1 with discounted
initial rate at 4%
Year 2 at 6%
Year 2 at 7%
$600 $800 $1,000 $1,200 $1,400 $1,600 $1,800
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For example, suppose you have a $200,000, 30-year payment-option ARM with a 2% rate for the first 3 months and
a 6% rate for the remaining 9 months of the year. Your minimum payment for the year is $739.24, as shown in the previous
graph. However, once the 6% rate is applied to your loan balance, you are no longer covering the interest costs. If you
continue to make minimum payments on this loan, your loan balance at the end of the first year of your mortgage would
be $201,118.or $1,118 more than you originally borrowed.
Because payment caps limit only the amount of payment increases, and not interest-rate increases, payments sometimes
do not cover all the interest due on your loan. This means that the unpaid interest is automatically added to your debt, and
interestmay be charged on that amount.Youmightowe the lendermore later in the loan termthan you didat the beginning.
A payment cap limits the increase in your monthly payment by deferring some of the interest. Eventually, you would
have to repay the higher remaining loan balance at the interest rate then in effect. When this happens, there may be
a substantial increase in your monthly payment.
Some mortgages include a cap on negative amortization. The cap typically limits the total amount you can owe to
110% to 125% of the original loan amount. When you reach that point, the lender will set the monthly payment amounts
to fully repay the loan over the remaining term. Your payment cap will not apply, and your payments could be
substantially higher. You may limit negative amortization by voluntarily increasing your monthly payment.
Be sure you know whether the ARM you are considering can have negative amortization.
Home Prices, Home Equity, and ARMs
Sometimes home prices rise rapidly, allowing people to quickly build equity in their homes. This can make
some people think that even if the rate and payments on their ARM get too high, they can avoid those higher
payments by refinancing their loan or, in the worst case, selling their home. It’s important to remember that
home prices do not always go up quickly.they may increase a little or remain the same, and sometimes they
fall. If housing prices fall, your home may not be worth as much as you owe on the mortgage. Also, you may
find it difficult to refinance your loan to get a lower monthly payment or rate. Even if home prices stay the same,
if your loan lets you make minimum payments (see payment-option ARMs on page 9), you may owe your
lender more on your mortgage than you could get from selling your home.
Prepayment penalties and conversion
If you get an ARM, you may decide later that you don’t want to risk any increases in the interest rate and payment
amount. When you are considering an ARM, ask for information about any extra fees you would have to pay if you
pay off the loan early by refinancing or selling your home, and whether you would be able to convert your ARM to a
fixed-rate mortgage.
Prepayment penalties
Some ARMs, including interest-only and payment-option ARMs, may require you to pay special fees or penalties
if you refinance or pay off the ARM early (usually within the first 3 to 5 years of the loan). Some loans have
prepayment penalties
for any reason (because you refinance or sell your home, for example). Other loans have
meaning that you will pay an extra fee or penalty only if you refinance the loan, but you will not pay a penalty if you sell
your home. Also, some loans may have prepayment penalties even if you make only a partial prepayment.
Prepayment penalties can be several thousand dollars. For example, suppose you have a 3/1 ARM with an initial
rate of 6%. At the end of year 2 you decide to refinance and pay off your original loan. At the time of refinancing, your
balance is $194,936. If your loan has a prepayment penalty of 6 months’ interest on the remaining balance, you would
owe about $5,850.
Sometimes there is a trade-off between having a prepayment penalty and having lower origination fees or lower
interest rates.
The lender may be willing to reduce or eliminate a prepayment penalty based on the amount you pay in loan fees
or on the interest rate in the loan contract.
If you have a hybrid ARM.such as a 2/28 or 3/27 ARM.be sure to compare the prepayment penalty period with
the ARM’s first adjustment period. For example, if you have a 2/28 ARM that has a rate and payment adjustment after
hard, meaning that you will pay an extra fee or penalty if you pay off the loan during the penalty periodsoft prepayment penalties,
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the second year, but the prepayment penalty is in effect for the first 5 years of the loan, it may be costly to refinance when
the first adjustment is made.
Most mortgages let you make additional principal payments with your monthly payment. In most cases, this is not
considered prepayment, and there usually is no penalty for these extra amounts. Check with your lender to make sure
there is no penalty if you think you might want to make this type of additional principal prepayment.
Conversion fees
Your agreement with the lender may include 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 using a formula given in your loan documents.
The interest rate or up-front fees may be somewhat higher for a convertible ARM. Also, a convertible ARM may
require a fee at the time of conversion.
Graduated-payment or stepped-rate loans
Some fixed-rate loans start with one rate for 1 or 2 years and then change to another rate for the remaining term of the
loan. While these are not ARMs, your payment will go up according to the terms of your contract. Talk with your lender or
brokerandreadtheinformation providedtoyoutomakesureyouunderstandwhenandbyhowmuch thepayment willchange.
Where to get information
Disclosures from lenders
You should receive information in writing about each ARM program you are interested in before you have paid a
nonrefundable fee. It is important that you read this information and ask the lender or broker about anything you don’t
understand.index rates, margins, caps, and other ARM features such as negative amortization. After you have applied
for a loan, you will get more information from the lender about your loan, including the APR, a payment schedule, and
whether the loan has a prepayment penalty.
The APR is the cost of your credit as a yearly rate. It takes into account interest, points paid on the loan, any fees
paid to the lender for making the loan, and any mortgage insurance premiums you may have to pay. You can compare
APRs on similar ARMs (for example, compare APRs on a 5/1 and a 3/1 ARM) to determine which loan will cost you less
in the long term, but you should keep in mind that because the interest rate for an ARM can change, APRs on ARMs
cannot be compared directly to APRs for fixed-rate mortgages.
You may want to talk with financial advisers, housing counselors, and other trusted advisers. Contact a local housing
counseling agency, call the U.S. Department of Housing and Urban Development toll-free at 800-569-4287, or visit
www.hud.gov/offices/hsg/sfh/hcc/hccprof14.cfm to find an agency near you.
Also, see our
assistance.
Where to go for help on page 16, for a list of federal agencies that can provide more information and
Newspapers and the Internet
When buying a home or refinancing your existing mortgage, remember to shop around. Compare costs and terms,
and negotiate for the best deal. Your local newspaper and the Internet are good places to start shopping for a loan. You
can usually find information on interest rates and points for several lenders. Since rates and points can change daily,
you’ll want to check information sources often when shopping for a home loan.
The Mortgage Shopping Worksheet on page 2 may also help you. Take it with you when you speak to each lender
or broker, and write down the information you obtain. Don’t be afraid to make lenders and brokers compete with each
other for your business by letting them know that you are shopping for the best deal.
Advertisements
Any initial information you receive about mortgages probably will come from advertisements or mail solicitations from
builders, real estate brokers, mortgage brokers, and lenders. Although this information can be helpful, keep in mind that
these are marketing materials.the ads and mailings are designed to make the mortgage look as attractive as possible.
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These ads may play up low initial interest rates and monthly payments, without emphasizing that those rates and
payments could increase substantially later. So, get all the facts.
Any ad for an ARM that shows an initial interest rate should also show how long the rate is in effect and the APR on
the loan. If the APR is much higher than the initial rate, your payments may increase a lot after the introductory period,
even if interest rates stay the same.
Choosing a mortgage may be the most important financial decision you will make. You are entitled to have all the
information you need to make the right decision. Don’t hesitate to ask questions about ARM features when you talk to
lenders, mortgage brokers, real estate agents, sellers, and your attorney, and keep asking until you get clear and
complete answers.
Glossary
Adjustable-rate mortgage (ARM)
A mortgage that does not have a fixed interest rate. The rate changes during the life of the loan based on movements
in an index rate, such as the rate for Treasury securities or the Cost of Funds Index. ARMs usually offer a lower initial
interest rate than fixed-rate loans. The interest rate fluctuates over the life of the loan based on market conditions, but
the loan agreement generally sets maximum and minimum rates. When interest rates increase, generally your loan
payments increase; and when interest rates decrease, your monthly payments may decrease.
Annual percentage rate (APR)
The cost of credit expressed as a yearly rate. For closed-end credit, such as car loans or mortgages, the APR includes
the interest rate, points, broker fees, and other credit charges that the borrower is required to pay. An APR, or an equivalent
rate, is not used in leasing agreements.
Balloon payment
A large extra payment that may be charged at the end of a mortgage loan or lease.
Buydown
When the seller pays an amount to the lender so that the lender can give you a lower rate and lower payments, usually
for an initial 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, interest rate
A limit on the amount your interest rate can increase. The two types of interest rate caps are
caps
next.
cap.
periodic adjustmentand life-time caps. Periodic adjustment caps limit the interest-rate increase from one adjustment period to theLifetime caps limit the interest-rate increase over the life of the loan. All adjustable-rate mortgages have an overall
Cap, payment
A limit on the amount that your monthly mortgage payment on a loan may change, usually a percentage of the loan.
The limit can be applied each time the payment changes or during the life of the mortgage. Payment caps may lead to
negative amortization because they do not limit the amount of interest the lender is earning.
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.
Conversion is usually 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.
Discounted initial rate (also known as a start rate or teaser rate)
In an ARM with a discounted initial rate, the lender offers you a lower rate and lower payments for part of the mortgage
term (usually for 1, 3, or 5 years). After the discount period, the ARM rate will probably go up depending on the index
rate. Discounts can occur in all types of mortgages, not just ARMs.
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Equity
In housing markets, equity is the difference between the fair market value of the home and the outstanding balance
on your mortgage plus any outstanding home equity loans. In vehicle leasing markets, equity is the positive difference
between the trade-in or market value of your vehicle and the loan payoff amount.
Hybrid ARM
These ARMs are a mix.or a hybrid.of a fixed-rate period and an adjustable-rate period. The interest rate is fixed
for the first several years of the loan; after that period, the rate can adjust annually. For example, hybrid ARMs can be
advertised as 3/1 or 5/1.the first number tells you how long the fixed interest-rate period will be and the second number
tells you how often the rate will adjust after the initial period. For example, a 3/1 loan has a fixed rate for the first 3 years
and then the rate adjusts once each year beginning in year 4.
Index
The economic indicator used to calculate interest-rate adjustments for adjustable-rate mortgages or other
adjustable-rate loans. The index rate can increase or decrease at any time.
rates for ARMs over an 11-year period,
See also the chart on page 6, Selected indexfor examples of common indexes that have changed in the past.
Interest
The rate used to determine the cost of borrowing money, usually stated as a percentage and as an annual rate.
Interest-only (I/O) ARM
Interest-only ARMs allow you to pay only the interest for a specified number of years, typically between 3 and 10
years. This arrangement allows you to have smaller monthly payments for a prescribed period. After that period, your
monthly payment will increase.even if interest rates stay the same.because you must start paying back the principal
and the interest each month. For some I-O loans, the interest rate adjusts during the I-O period as well.
Margin
The number of percentage points the lender adds to the index rate to calculate the interest rate of an adjustable-rate
mortgage (ARM) at each adjustment.
Negative amortization
Occurs when the monthly payments in an adjustable-rate mortgage loan do not cover all the interest owed. The
interest that is not paid in the monthly payment is added to the loan 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 that are not high enough to cover the interest due or when the
minimum payments are set at an amount lower than the amount you owe in interest.
Payment-option ARM
An ARM that allows the borrower to choose among several payment options each month. The options typically include
(1)atraditionalamortizingpaymentofprincipalandinterest,(2)aninterest-onlypayment, or (3) aminimum(or limited)payment
that may be less than the amount of interest due that month. If the borrower chooses the minimum-payment option, the
amount of any interest that is not paid will be added to the principal of the loan.
See also Negative amortization on page 15.
Points (also called discount points)
One point is equal to 1 percent of the principal amount of a mortgage loan. For example, if the mortgage is $200,000,
one point equals $2,000. Lenders frequently charge points in both fixed-rate and adjustable-rate mortgages to cover loan
origination costs or to provide additional compensation to the lender or broker. These points usually are paid at closing and
maybepaidbytheborrower or thehome seller, or may be splitbetween them. Insome cases, the money neededtopaypoints
canbe borrowed (incorporated in the loan amount), but doing so will increase the loan amount andthe total costs. Discount
points (also called discount fees) are points that the borrower voluntarily chooses to pay in return for a lower interest rate.
Prepayment penalty
Extra fees that may be due if you pay off your loan early by refinancing the loan or by selling the home. The penalty
is usually limited to the first 3 to 5 years of the loan’s term. If your loan includes a prepayment penalty, make sure you
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understand the cost. Compare the length of the prepayment penalty period with the first adjustment period of the
ARM to see if refinancing is cost-effective before the loan first adjusts. Some loans may have a prepayment penalty
even if you make a partial prepayment. Ask the lender for a loan without a prepayment penalty and the cost of that
loan.
Principal
The amount of money borrowed or the amount still owed on a loan.
Where to go for help
For additional information or to file a complaint about a bank, savings and loan, credit union, or other financial institution,
contact one of the following federal agencies, depending on the type of institution.
State-chartered banks that are members of the Federal Reserve System
Federal Reserve Consumer Help
PO Box 1200
Minneapolis, MN 55480
(888) 851-1920 (toll free)
(877) 766-8533 (TTY) (toll free)
(877) 888-2520 (fax) (toll free)
e-mail: ConsumerHelp@FederalReserve.gov
www.FederalReserveConsumerHelp.gov
Federally insured state-chartered banks that are not members of the Federal Reserve System
Federal Deposit Insurance Corporation (FDIC)
Consumer Response Center
2345 Grand Blvd., Suite 100
Kansas City, MO 64108
(877) ASK-FDIC (877-275-3342) (toll free)
e-mail: consumeralerts@fdic.gov
www.fdic.gov/consumers/consumer/ccc/index.html
National banks (banks with .National. in the name or .N.A.. after the name) and national-bank-owned mortgage
companies
Office of the Comptroller of the Currency (OCC)
Customer Assistance Group
1301 McKinney Street, Suite 3450
Houston, TX 77010
(800) 613-6743 (toll free)
(713) 336-4301 (fax)
e-mail: customer.assistance@occ.treas.gov
www.occ.treas.gov
www.helpwithmybank.gov
Savings and loan associations (federally chartered and some state chartered)
Office of Thrift Supervision (OTS)
Consumer Affairs
1700 G Street NM, 6th Floor
Washington, DC 20552
(800) 842-6929 (toll free)
(800) 877-8339 (TTY) (toll free)
www.ots.treas.gov
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Federally chartered credit unions (those with .Federal. in the name)
National Credit Union Administration (NCUA)
Office of Public and Congressional Affairs
1775 Duke Street
Alexandria, VA 22314
(800) 755-1030 (toll free)
(703) 518-6409 (fax)
e-mail: consumerassistance@ncua.gov
www.ncua.gov/ConsumerInformation/index.htm
State-chartered credit unions
Contact the regulartory agency in the state in which the credit union is chartered.
Finance companies, stores, auto dealers, mortgage companies, and other lenders, and credit bureaus
Federal Trade Commission (FTC)
Consumer Response Center - 240
600 Pennsylvania Avenue NW
Washington, DC 20580
(877) FTC-HELP (877-382-4357) (toll free)
(866) 653-4261 (TTY) (toll free)
www.ftc.gov
www.ftc.gov/bcp/edu/microsites/idtheft
More resources and ordering information
Looking for the Best Mortgage.Shop, Compare, Negotiate
(at www.federalreserve.gov/pubs/mortgage/mortb_1.htm)
Interest-Only Mortgage Payments and Payment-Option ARMs.Are They for You?
(at www.federalreserve.gov/pubs/mortgage_interestonly/)
A Consumer’s Guide to Mortgage Lock-Ins
(at www.federalreserve.gov/pubs/lockins/default.htm)
A Consumer’s Guide to Mortgage Settlement Costs
(at www.federalreserve.gov/pubs/settlement/default.htm)
Know Before You Go . . .To Get a Mortgage: A Guide to Mortgage Products and a Glossary of Lending Terms
(at www.bos.frb.org/consumer/knowbeforeyougo/mortgage/mortgage.pdf)
Partners Online Mortgage Calculator
(at www.frbatlanta.org/partnerssoftwareonline/dsp_main.cfm)
Formore information onmortgage and other financial topics, includinginteractivecalculators, visit www.federalreserve.gov/
consumerinfo. To order print copies of brochures, visit www.federalreserve.gov/pubs/order.htm.
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