Consumer Handbook on Adjustable Rate Mortgages

Table of contents

Initial rate and payment ...................................................................... 6

The adjustment period ........................................................................ 6

The index ............................................................................................... 7

The margin ............................................................................................ 8

Interest-rate caps .................................................................................. 10

Payment caps ........................................................................................ 13

Hybrid ARMs ....................................................................................... 15

Interest-only ARMs .............................................................................. 15

Payment-option ARMs ........................................................................ 16

Discounted interest rates ..................................................................... 19

Payment shock ...................................................................................... 20

Negative amortization—when you owe more

money than you borrowed ................................................................. 22

Prepayment penalties and conversion .............................................. 24

Graduated-payment or stepped-rate loans ...................................... 25

Disclosures from lenders .................................................................... 27

Newspapers and the Internet ............................................................. 28

Advertisements .................................................................................... 28

This information was prepared by the Board of Governors of the

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

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

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

Your monthly payments could change. They could go up —

sometimes by a lot—even if interest rates don’t go up. See

page 20.

Your payments may not go down much, or at all—even if

interest rates go down. See page 11.

You could end up owing more money than you borrowed—

even if you make all your payments on time. See page 22.

you might pay a penalty. See page 24.

page 2 can help you get started.

Name of lender or broker and contact information

Mortgage amount

Loan term (e.g., 15 years, 30 years)

Loan description

Fixed-rate mortgage interest rate and annual percentage rate (APR)

(For graduated-payment or stepped-rate mortgages, use the ARM columns.)

How long does the initial rate apply?

What is the index and what is the current rate? (See chart on page 8.)

What is the margin for this loan?

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?

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?

Does this include taxes and insurance? Condo or homeowner’s association fees?

If not, what are the estimates for these amounts?

…stays the same?

…goes up 2%?

…goes down 2%?

What is an ARM?

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.

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

Lenders generally charge lower initial interest rates for ARMs

same loan amount. Moreover, your ARM could be less expensive

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

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

How ARMs work:

the basic features

The initial rate and payment amount on an ARM will remain in

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

that your rate and payments will be a lot higher when the loan

adjusts, even if general interest rates remain the same.

With most ARMs, the interest rate and monthly payment change

every month, quarter, year, 3 years, or 5 years. The period between

with an adjustment period of 1 year 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.

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.

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

their own cost of funds as an index, rather than using other

of this information in major newspapers and on the Internet.

following chart shows a few common indexes over an 11-year

period (1996–2008). As you can see, some index rates tend to be

bases interest-rate adjustments on the average value of an index

over time, your interest rate would not change as dramatically.

To set the interest rate on an ARM, lenders add a few percentage

to the margin plus the index. If the initial rate on the loan is less

example, if the lender uses an index that currently is 4% and

adds a 3% margin, the fully indexed rate would be

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 interest you will have to pay on your mortgage. In comparing

ARMs, look at both the index and margin for each program.

An interest-rate cap places a limit on the amount your interest

rate can increase. Interest caps come in two versions:

rate can adjust up or down from one adjustment period

the life of the loan. By law, virtually all ARMs must have a

lifetime cap.

Let’s suppose you have an ARM with a periodic adjustment

rate has risen 3%. The following example shows what happens.

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.

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.

your payment might increase even though the index rate has

stayed the same or declined.

The following example shows how carryovers work. Suppose

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 increases 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.

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.

In addition to interest-rate caps, many ARMs—including

payment-option ARMs (discussed on page 16)—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

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

to the balance of your loan and will lead to negative amortization.

Some ARMs with payment caps do not have periodic interestrate

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

a 30-year loan and you 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.

.

Types of ARMs

might also see ads for 7/1 or 10/1 ARMs. These loans are a mix—

the case of 3/1 or 5/1 ARMs:

period will be, and

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.

years. This allows you to have smaller monthly payments for a

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

Keep in mind that the longer the I-O period, the higher your

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:

the amount you owe on your mortgage. These payments are

based on a set loan term, such as a 15-, 30-, or 40-year payment

schedule.

reduce the amount you owe on your mortgage as you make

your payments.

amount of interest due that month and may not reduce

the amount you owe on your mortgage. If you choose this

option, the amount of any interest you do not pay will be

the 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

The interest rate on a payment-option ARM is typically very

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,

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

would go up substantially.

More information on interest-only and payment-option ARMs

consumerinfo/mortgages.htm).

Consumer cautions

indexed ARM rate (that is, lower than the sum of the index plus

the margin). Such rates—called discounted rates, start rates, or

discounted rate expires.

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

that means that the loan is a good one for you. You should carefully

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

$954.83.

With a discounted ARM, your initial payment will probably

remain at $954.83 for only a limited time—and any savings

over the remaining life of the mortgage. If you are considering a

discount ARM, be sure to compare future payments with those

using a deeply discounted initial rate, you run the risk of payment

shock, negative amortization, or prepayment penalties or

conversion fees.

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.

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

If you have an interest-only ARM, payment shock can also occur

when the interest-only period ends. Or, if you have a paymentoption

ARM, payment shock can happen when the loan is recast.

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

could also face much higher payments in the future.

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 paymentoption

mortgage or because your loan has a payment cap.

For example, suppose you have a $200,000, 30-year paymentoption

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

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 interest

may be charged on that amount. You might owe the lender more

later in the loan term than you did at 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

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.

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

Some ARMs, including interest-only and payment-option ARMs,

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

your loan has a prepayment penalty of 6 months’ interest on the

remaining balance, you would owe about $5,850.

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

adjustment period. For example, if you have a 2/28 ARM that

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.

Your agreement with the lender may include a clause that lets

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.

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 broker and read

the information provided to you to make sure you understand

when and by how much the payment will change.

Where to get information

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

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

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/

agencies that can provide more information and assistance.

remember to shop around. Compare costs and terms, and negotiate

for the best deal. Your local newspaper and the Internet are

information on interest rates and points for several lenders. Since

rates and points can change daily, you’ll want to check information

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

deal.

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

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

the APR is much higher than the initial rate, your payments may

stay the same.

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

asking until you get clear and complete answers.

.

Glossary

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

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.

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.

A large extra payment that may be charged at the end of a

mortgage loan or lease.

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.

A limit on the amount that your interest rate can increase. The

interest-rate increase over the life of the loan. All adjustable-rate

mortgages have an overall cap.

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.

A provision in some ARMs that allows you to change the ARM

feature may be available at extra cost.

a lower rate and lower payments for part of the mortgage term

rate will probably go up depending on the index rate. Discounts

can occur in all types of mortgages, not just ARMs.

market value of the home and the outstanding balance on your

mortgage plus any outstanding home equity loans. In vehicle

amount.

annually. For example, hybrid ARMs can be advertised as 3/1 or

each year beginning in year 4.

The economic indicator used to calculate interest-rate adjustments

for adjustable-rate mortgages or other adjustable-rate loans. The

examples of common indexes that have changed in the past.

The rate used to determine the cost of borrowing money, usually

stated as a percentage and as an annual rate.

number of years, typically between 3 and 10 years. This arrangement

allows you to have smaller monthly payments for a prescribed

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.

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.

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.

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.

An ARM that allows the borrower to choose among several

payment options each month. The options typically include (1) a

traditional amortizing payment of principal and interest, (2) an

interest-only payment, or (3) a minimum (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

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

costs or to provide additional compensation to the lender

or broker. These points usually are paid at closing and may be

paid by the borrower or the home seller, or may be split between

them. In some cases, the money needed to pay points can be

borrowed (incorporated in the loan amount), but doing so will

increase the loan amount and the total costs. Discount points

(also called discount fees) are points that the borrower voluntarily

chooses to pay in return for a lower interest rate.

includes a prepayment penalty, make sure you understand the

cost. Compare the length of the prepayment penalty period with

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.

The amount of money borrowed or the amount still owed on a

loan.

Where to go for help

one of the following federal agencies, depending on the type

of institution.

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

Federal Deposit Insurance Corporation (FDIC)

Consumer Response Center

1100 Walnut Street, Box #11

Kansas City, MO 64106

(877) ASK-FDIC (877-275-3342) (toll free)

e-mail: consumeralerts@fdic.gov

www.fdic.gov/consumers/consumer/ccc/index.html

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

National Credit Union Administration (NCUA)

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

Contact the regulatory agency in the state in which the credit

union is chartered.

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)

More resources and ordering

information

(at www.federalreserve.gov/pubs/mortgage/mortb_1.htm)

(at www.federalreserve.gov/pubs/mortgage_interestonly/)

(at www.federalreserve.gov/pubs/lockins/default.htm)

(at www.bos.frb.org/consumer/knowbeforeyougo/mortgage/

mortgage.pdf)

including interactive calculators, visit www.federalreserve.gov/

consumerinfo. To order print copies of brochures, visit www.

federalreserve.gov/pubs/order.htm.