CONSUMERHANDBOOK ON

ADJUSTABLE RATEMORTGAGES

Federal Reserve BoardOffice of Thrift Supervision

This booklet was originally prepared inconsultation with the followingorganizations:

American Bankers AssociationAmerica’s Community Bankers

(formerly the National Council of Sav-ings Institutions and the U.S. League ofSavings Institutions)

Comptroller of the CurrencyConsumer Federation of AmericaCredit Union National Association, Inc.Federal Deposit Insurance CorporationFederal Reserve Board’s Consumer

Advisory CouncilFederal Trade CommissionIndependent Bankers Association of AmericaMortgage Bankers Association of AmericaMortgage Insurance Companies of AmericaNational Association of Federal Credit UnionsNational Association of Home BuildersNational Association of RealtorsNational Credit Union AdministrationOffice of Special Advisor to the President

for Consumer AffairsThe Consumer Bankers AssociationU.S. Department of Housing and

Urban Development

With special thanks to Fannie Mae (formerly theFederal National Mortgage Association) andFreddie Mac (formerly the Federal Home LoanMortgage Corporation).

1

The Federal Reserve Board and the Officeof Thrift Supervision prepared this bookleton adjustable-rate mortgages (ARMs) inresponse to a request from the HouseCommittee on Banking, Finance and UrbanAffairs and in consultation with manyother agencies and trade and consumergroups. It is designed to help consumersunderstand an important and complexmortgage option available to home buyers.

We believe a fully informed consumer isin the best position to make a soundeconomic choice. If you are buying a home,and looking for a home loan, this bookletwill provide useful basic information aboutARMs. It cannot provide all the answersyou will need, but we believe it is a goodstarting point.

2

PEOPLE ARE ASKING . . .

�Some newspaper ads for home loans showsurprisingly 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 mayhave low rates for a short time—maybeonly for the first year. After that, the ratescan be adjusted on a regular basis. Thismeans that the interest rate and the amountof the monthly payment can go up or down.

�Will I know in advance how much my pay-ment may go up?�

With an adjustable-rate mortgage, yourfuture monthly payment is uncertain. Sometypes of ARMs put a ceiling on your pay-ment increase or rate increase from oneperiod to the next. Virtually all must put aceiling on interest-rate increases over thelife of the loan.

�Is an ARM the right type of loan for me?�

That depends on your financial situationand the terms of the ARM. ARMs carryrisks in periods of rising interest rates, butcan be cheaper over a longer term if interestrates decline. You will be able to answerthe question better once you understandmore about ARMs. This booklet shouldhelp.

3

Mortgages have changed, and so have thequestions that consumers need to ask andhave answered.

Shopping for a mortgage used to be arelatively simple process. Most homemortgage loans had interest rates that didnot change over the life of the loan. Choos-ing among these fixed-rate mortgage loansmeant comparing interest rates, monthlypayments, fees, prepayment penalties, anddue-on-sale clauses.

Today, many loans have interest rates(and monthly payments) that can changefrom time to time. To compare one ARMwith another or with a fixed-rate mortgage,you need to know about indexes, margins,discounts, caps, negative amortization, andconvertibility. You need to consider themaximum amount your monthly paymentcould increase. Most important, you needto compare what might happen to yourmortgage costs with your future ability topay.

This booklet explains how ARMs workand some of the risks and advantages toborrowers that ARMs introduce. It dis-cusses features that can help reduce therisks and gives some pointers about adver-tising and other ways you can get informa-tion from lenders. Important ARM termsare defined in a glossary on page 19. And achecklist at the end of the booklet shouldhelp you ask lenders the right questionsand figure out whether an ARM is right foryou. Asking lenders to fill out the checklistis a good way to get the information youneed to compare mortgages.

4

WHAT IS AN ARM?

With a fixed-rate mortgage, the interest ratestays the same during the life of the loan.But with an ARM, the interest rate changesperiodically, usually in relation to anindex, and payments may go up or downaccordingly.

Lenders generally charge lower initialinterest rates for ARMs than for fixed-ratemortgages. This makes the ARM easier onyour pocketbook at first than a fixed-ratemortgage for the same amount. It alsomeans that you might qualify for a largerloan because lenders sometimes make thisdecision on the basis of your currentincome and the first year’s payments.Moreover, your ARM could be less expen-sive over a long period than a fixed-ratemortgage—for example, if interest ratesremain steady or move lower.

Against these advantages, you have toweigh the risk that an increase in interestrates would lead to higher monthly pay-ments in the future. It’s a trade-off—you geta lower rate with an ARM in exchange forassuming more risk.

Here are some questions you need toconsider:• Is my income likely to rise enough to

cover higher mortgage payments ifinterest 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? (Ifyou plan to sell soon, rising interest ratesmay not pose the problem they do if youplan to own the house for a long time.)

• Can my payments increase even ifinterest rates generally do not increase?

5

HOW ARMs WORK:THE BASIC FEATURES

The Adjustment PeriodWith most ARMs, the interest rate andmonthly payment change every year, everythree years, or every five years. However,some ARMs have more frequent interestand payment changes. The period betweenone rate change and the next is called theadjustment period. So, a loan with anadjustment period of one year is called aone-year ARM, and the interest rate canchange once every year.

The IndexMost lenders tie ARM interest rate changesto changes in an “index rate.” Theseindexes usually go up and down with thegeneral movement of interest rates. If theindex rate moves up, so does your mortgagerate in most circumstances, and you willprobably have to make higher monthlypayments. On the other hand, if the indexrate goes down your monthly payment maygo down.

Lenders base ARM rates on a variety ofindexes. Among the most common indexesare the rates on one-, three-, or five-yearTreasury securities. Another common indexis the national or regional average cost offunds to savings and loan associations. Afew lenders use their own cost of funds asan index, which—unlike other indexes—they have some control. You should askwhat index will be used and how often itchanges. Also ask how it has fluctuated inthe past and where it is published.

6

The MarginTo determine the interest rate on an ARM,lenders add to the index rate a few percent-age points called the “margin.” The amountof the margin can differ from one lender toanother, but it is usually constant over thelife of the loan.

Index rate + margin =ARM interest rate

Let’s say, for example, that you arecomparing ARMs offered by two differentlenders. Both ARMs are for 30 years with aloan amount of $65,000. (All the examplesused in this booklet are based on thisamount for a 30-year term. Note that thepayment amounts shown here do notinclude items like taxes or insurance.)

Both lenders use the one-year Treasuryindex. But the first lender uses a 2%margin, and the second lender uses a 3%margin. Here is how that difference in themargin would affect your initial monthlypayment.

7

Home sale price: $ 85,000Less down payment: � 20,000Mortgage amount: $ 65,000

Mortgage term: 30 years

FIRST LENDEROne-year index = 8%Margin = 2%ARM interest rate = 10%Monthly payment @ 10% = $570.42

SECOND LENDEROne-year index = 8%Margin = 3%ARM interest rate = 11 %Monthly payment @ 11 % = $619.01

In comparing ARMs, look at both the indexand margin for each program. Some in-dexes have higher average values, but theyare usually used with lower margins. Besure to discuss the margin with yourlender.

8

CONSUMER CAUTIONS

DiscountsSome lenders offer initial ARM rates thatare lower than the sum of the index and themargin. Such rates, called discounted rates,are often combined with large initial loanfees (“points”) and with much higherinterest rates after the discount expires.

Very large discounts are often arrangedby the seller. The seller pays an amount tothe lender so the lender can give you alower rate and lower payments early in themortgage term. This arrangement is referredto as a “seller buydown.” The seller mayincrease the sales price of the home tocover the cost of the buydown.

A lender may use a low initial rate todecide whether to approve your loan, basedon your ability to afford it. You should becareful to consider whether you will beable to afford payments in later years whenthe discount expires and the rate is ad-justed.

Here is how a discount might work. Let’sassume the one-year ARM rate (index rateplus margin) is at 10%. But your lender isoffering an 8% rate for the first year. Withthe 8% rate, your first year monthly pay-ment would be $476.95.

But don’t forget that with a discountedARM, your low initial payment will prob-ably not remain low for long, and that anysavings during the discount period may bemade up during the life of the mortgage orbe included in the price of the house. Infact, if you buy a home using this kind ofloan, you run the risk of . . .

9

Payment ShockPayment shock may occur if your mortgagepayment rises very sharply at the firstadjustment. Let’s see what happens in thesecond year with your discounted 8% ARM.

As the example shows, even if the indexrate stays the same, your monthly paymentwould go up from $476.95 to $568.82 in thesecond year.

Suppose that the index rate increases 2%in one year and the ARM rate rises to alevel of 12%.

That’s an increase of almost $200 in yourmonthly payment. You can see what mighthappen if you choose an ARM because of alow initial rate. You can protect yourselffrom large increases by looking for amortgage with features, described next,which may reduce this risk.

ARM Interest Rate Monthly Payment

First year (w/discount) 8% $476.95

2nd year @ 10 % $568.82

ARM Interest Rate Monthly Payment

First year (w/discount) 8% $476.95

2nd year @ 12% $665.43

10

HOW CAN I REDUCEMY RISK?

Besides an overall rate ceiling, most ARMsalso have “caps” that protect borrowersfrom extreme increases in monthly pay-ments. Others allow borrowers to convertan ARM to a fixed-rate mortgage. Whilethese may offer real benefits, they may alsocost more, or add special features, such asnegative amortization.

Interest-Rate CapsAn interest-rate cap places a limit on theamount your interest rate can increase.Interest caps come in two versions:

• Periodic caps, which limit the interest-rate increase from one adjustment periodto the next; and

• Overall caps, which limit the interestrate increase over the life of the loan.

By law, virtually all ARMs must have anoverall cap. Many have a periodic interestrate cap.

Let’s suppose you have an ARM with aperiodic interest rate cap of 2%. At thefirst adjustment, the index rate goes up3%. The example shows what happens.

ARM Interest Rate Monthly Payment

First year @ 10% $570.42

2nd year @ 13%(without cap) $7 1 7.1 2

2nd year @ 12%(with cap) $667.30

Difference in 2nd year between payment withcap and payment without = $49.82

11

A drop in interest rates does not alwayslead to a drop in monthly payments. Infact, with some ARMs that have interestrate caps, your payment amount mayincrease even though the index rate hasstayed the same or declined. This mayhappen when an interest rate cap has beenholding your interest rate down below thesum of the index plus margin. If a rate capholds down your interest rate, increases tothe index that were not imposed due to thecap may carry over to future rate adjust-ments.

With some ARMs, paymentsmay increase even if the indexrate stays the same or declines.

To show how carryovers work, the indexin the example below increased 3% duringthe first year. Because this ARM limits rateincreases to 2% at any one time, the rate isadjusted by only 2%, to 12% for the second

ARM Interest Rate Monthly Payment

First year @ 10% $570.42

If index rises 3% . . .

2nd year @ 12%(with 2% rate cap) $667.30

If index stays the samefor the 3rd year @ 13% $716.56

Even though the index stays the same in 3rdyear, payment goes up $49.26

12

year. However, the remaining 1% increasein the index carries over to the next timethe creditor can adjust rates. So when thecreditor adjusts the interest rate for thethird year, the rate increases 1%, to 13%,even though there is no change in the indexduring the second year.

In general, the rate on your loan can go upat any scheduled adjustment date when theindex plus the margin is higher than the rateyou 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 increases1% in each of the first ten years. With a5% overall cap, your payment would neverexceed $813.00—compared to the $1,008.64that it would have reached in the tenth yearbased on a 19% interest rate.

Payment CapsSome ARMs include payment caps, whichlimit your monthly payment increase at thetime of each adjustment, usually to apercentage of the previous payment. Inother words, with a 7½% payment cap, a

ARM Interest Rate Monthly Payment

First year @ 10% $570.42

10th year @ 15%(with cap) $813.00

13

payment of $100 could increase to no morethan $107.50 in the first adjustment period,and to no more than $115.56 in the second.

Let’s assume that your rate changes inthe first year by 2 percentage points, butyour payments can increase by no morethan 7½% in any one year. Here’s whatyour payments would look like:

Many ARMs with payment caps do nothave periodic interest rate caps.

Negative AmortizationIf your ARM contains a payment cap, besure to find out about “negative amortiza-tion.” Negative amortization means themortgage balance increases. This occurswhenever your monthly mortgage pay-ments are not large enough to pay all of theinterest due on your mortgage.

Because payment caps limit only theamount of payment increases, and notinterest-rate increases, payments some-

ARM Interest Rate Monthly Payment

First year @ 10% $570.42

2nd year @ 12%(without payment cap) $667.30

2nd year @ 12%(with 7 1/2 % payment cap) $613. 20

Difference in monthly payment = $54.10

14

times do not cover all of the interest due onyour loan. This means that the interestshortage in your payment is automaticallyadded to your debt, and interest may becharged on that amount. You might there-fore owe the lender more later in the loanterm than you did at the start. However, anincrease in the value of your home maymake up for the increase in what you owe.

The next illustration uses the figuresfrom the preceding example to show hownegative amortization works during oneyear. Your first 12 payments of $570.42,based on a 10% interest rate, paid thebalance down to $64,638.72 at the end ofthe first year. The rate goes up to 12% inthe second year. But because of the 7 ½%payment cap, payments are not highenough to cover all the interest. Theinterest shortage is added to your debt(with interest on it), which producesnegative amortization of $420.90 during thesecond year.

Beginning loan amount = $65,000

Loan amount @ end of first year =$64,638.72

Negative amortization during 2nd year =$420.90

Loan amount @ end of 2nd year =$65,059.62 ($64,638.72 + $420.90)

(If you sold your house at this point, youwould owe almost $60 more than theamount you originally borrowed.)

15

To sum up, the payment cap limitsincreases in your monthly payment bydeferring some of the increase in interest.Eventually, you will have to repay thehigher remaining loan balance at the ARMrate then in effect. When this happens,there may be a substantial increase in yourmonthly payment.

Some mortgages contain a cap on nega-tive amortization. The cap typically limitsthe total amount you can owe to 125% ofthe original loan amount. When that pointis reached, monthly payments may be setto fully repay the loan over the remainingterm, and your payment cap may not apply.You may limit negative amortization byvoluntarily increasing your monthlypayment.

Be sure to discuss negative amortizationwith the lender to understand how it willapply to your loan.

Prepayment and ConversionIf you get an ARM and your financialcircumstances change, you may decide thatyou don’t want to risk any further changesin the interest rate and payment amount.When you are considering an ARM, askfor information about prepayment andconversion.

16

Prepayment. Some agreements mayrequire you to pay special fees or penaltiesif you pay off the ARM early. Many ARMsallow you to pay the loan in full or in partwithout penalty whenever the rate isadjusted. Prepayment details are sometimesnegotiable. If so, you may want to negotiatefor no penalty, or for as low a penalty aspossible.

Conversion. Your agreement with thelender can have a clause that lets youconvert the ARM to a fixed-rate mortgage atdesignated times. When you convert, thenew rate is generally set at the currentmarket rate for fixed-rate mortgages.

The interest rate or up-front fees may besomewhat higher for a convertible ARM.Also, a convertible ARM may require aspecial fee at the time of conversion.

17

WHERE TO GETINFORMATION

Before you actually apply for a loan andpay a fee, ask for all the information thelender has on the loan you are considering.It is important that you understand indexrates, margins, caps, and other ARMfeatures like negative amortization. You canget helpful information from advertise-ments and disclosures, which are subject tocertain federal standards.

AdvertisingYour first information about mortgagesprobably will come from newspaperadvertisements placed by builders, realestate brokers, and lenders. While thisinformation can be helpful, keep in mindthat the ads are designed to make themortgage look as attractive as possible.These ads may play up low initial interestrates and monthly payments, withoutemphasizing that those rates and paymentslater could increase substantially. So, getall the facts.

A federal law, the Truth in Lending Act,requires mortgage advertisers, once theybegin advertising specific terms, to givefurther information on the loan. For ex-ample, if they want to show the interestrate or payment amount on the loan, theymust also tell you the annual percentagerate (APR) and whether that rate may goup. The APR, the cost of your credit as ayearly rate, reflects more than just a lowinitial rate. It takes into account interest,points paid on the loan, any loan origina-tion fee, and any mortgage insurancepremiums you may have to pay.

Ads may play up low initialrates. Get all the facts.

18

Disclosures From LendersFederal law requires the lender to give youinformation about ARMs, in most casesbefore you apply for a loan. The lender alsois required to give you information whenyou apply for a mortgage. You should get awritten summary of important terms andcosts of the loan. Some of these are thefinance charge, the APR, and the paymentterms.

Read information fromlenders�and ask questions�before committing yourself.

Selecting a mortgage may be the mostimportant financial decision you willmake, and you are entitled to all theinformation you need to make the rightdecision. Don’t hesitate to ask questionsabout ARM features when you talk tolenders, real estate brokers, sellers, andyour attorney, and keep asking until you getclear and complete answers. The checklistat the back of this pamphlet is intended tohelp you compare terms on different loans.

19

GLOSSARY

Adjustable-Rate Mortgage (ARM)A mortgage where the interest rate is notfixed, but changes during the life of theloan in line with movements in an indexrate. You may also see ARMs referred to asAMLs (adjustable-mortgage loans) or VRMs(variable-rate mortgages).

Annual Percentage Rate (APR)A measure of the cost of credit, expressedas a yearly rate. It includes interest as wellas other charges. Because all lenders followthe same rules to ensure the accuracy ofthe APR, it provides consumers with a goodbasis for comparing the cost of loans,including mortgages.

Assumability

When a home is sold, the seller may beable to transfer the mortgage to the newbuyer. This means the mortgage is assum-able. Lenders generally require a creditreview of the new borrower and may chargea fee for the assumption. Some mortgagescontain a due-on-sale clause, which meansthat the mortgage may not be transferableto a new buyer. Instead, the lender maymake you pay the entire balance that is duewhen you sell the home. Assumability canhelp you attract buyers if you sell yourhome.

20

BuydownWith a buydown, the seller pays an amountto the lender so that the lender can giveyou a lower rate and lower payments,usually for an early period in an ARM. Theseller may increase the sales price to coverthe cost of the buydown. Buydowns canoccur in all types of mortgages, not justARMs.

CapA limit on how much the interest rate orthe monthly payment can change, either ateach adjustment or during the life of themortgage. Payment caps don’t limit theamount of interest the lender is earning, sothey may cause negative amortization.

Conversion Clause

A provision in some ARMs that allows youto change the ARM to a fixed-rate loan atsome point during the term. Usuallyconversion is allowed at the end of the firstadjustment period. At the time of theconversion, the new fixed rate is generallyset at one of the rates then prevailing forfixed-rate mortgages. The conversionfeature may be available at extra cost.

21

DiscountIn an ARM with an initial rate discount,the lender gives up a number of percentagepoints in interest to give you a lower rateand lower payments for part of the mort-gage term (usually for one year or less).After the discount period, the ARM ratewill probably go up depending on theindex rate.

IndexThe index is the measure of interest ratechanges that the lender uses to decide howmuch the interest rate on an ARM willchange over time. No one can be sure whenan index rate will go up or down. To helpyou get an idea of how to compare differentindexes, the following chart shows a fewcommon indexes over a ten-year period(1987-97). As you can see, some index rates

SELECTEDINDEX RATES FOR ARMs

OVER A TEN-YEAR PERIOD

National AverageMortgage Contract

Interest Rate

1-year TreasuryRate

10%

8%

6%

4%

1987 1989 1991 1993 1995 1997

Cost of Fundsfor Savings and

Loan Associations

22

tend to be highter than others, and somemore volatile. (But if a lender bases interestrate adjustments on the average value of anindex over time, your interest rate would notbe as volatile.) You should ask your lenderhow the index for any ARM you are consid-ering has changed in recent years, and whereit is reported.

Margin

The number of percentage points the lenderadds to the index rate to calculate the ARMinterest rate at each adjustment.

Negative Amortization

Amortization means that monthly pay-ments are large enough to pay the interestand reduce the principle on your mortgage.Negative amortization occurs when themonthly payments do not cover all theinterest cost. The interest cost that isn’tcovered is added to the unpaid principalbalance. This means that even after makingmany payments, you could owe more thanyou did at the beginning of the loan.Negative amortization can occur when anARM has a payment cap that results inmonthly payments not high enough tocover the interest due.

23

PointsA point is equal to one percent of theprincipal amount of your mortgage. Forexample, if you get a mortgage for $65,000,one point means you pay $650 to thelender. Lenders frequently charge points inboth fixed-rate and adjustable-rate mort-gages in order to increase the yield on themortgage and to cover loan closing costs.These points usually are collected at closingand may be paid by the borrower or thehome seller, or may be split between them.

MORTGAGE CHECKLISTAsk your lender to help fill out this checklist.

Mortgage amount

Basic Features for Comparison

Fixed-rate annual percentage rate(the cost of your credit as a yearly rate whichincludes 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 beafter twelve months if the index rate:

stays the same

goes up 2%

goes down 2%

What will my monthly payments be afterthree 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 mort-gage and remember it may run 30 years.

FRB 10-200,000-1298-C

Mortgage A Mortgage B

$ $

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________

________________ ________________