|FHA adjustable rate mortgages (ARM loans)
are one of the best adjustable rate mortgages available.You may use this FHA adjustable
rate mortgage loan for 1-4 unit homes, as well as condominiums, townhomes, and PUDs. For
information on FHA adjustable rate mortgages directly visit the FHA adjustable rate mortgage page.
Learn how adjustable rate mortgages work by reviewing the Consumer Handbook
of Adjustable Rate Mortgages. This will help you determine if an adjustable rate mortgage
is right for you.
Adjustable Rate Mortgage Consumer Handbook*
Federal Reserve Board Office of Thrift Supervision
EQUAL HOUSING OPPORTUNITY
This booklet was prepared in consultation with the following
American Bankers Association Comptroller of the Currency Consumer
Federation of America Credit Union National Association, Inc. Federal Deposit Insurance
Corporation Federal Reserve Board's Consumer Advisory Council Federal Trade Commission
Independent Bankers Association of America Mortgage Bankers Association of America
Mortgage Insurance Companies of America National Association of Federal Credit Unions
National Association of Home Builders National Association of Realtors National Council of
Savings Institutions National Credit Union Administration Office of Special Advisor to the
President for Consumer Affairs The Consumer Bankers Association U.S. Department of Housing
and Urban Development U.S. League of Savings Institutions
With special thanks to the Federal National Mortgage Association and
the Federal Home Loan Mortgage Corporation
The Federal Reserve Board and the Office of Thrift Supervision
prepared this booklet on adjustable rate mortgages (Adjustable Rate Mortgages) in response
to a request from the House Committee on Banking, Finance and Urban Affairs and in
consultation with many other agencies and trade and consumer groups. It is designed to
help consumers understand an important and complex mortgage option available to home
We believe a fully informed consumer is in the best position to make
a sound economic choice. If you are buying a home, and looking for a home loan, this
booklet will provide useful basic information about Adjustable Rate Mortgages. It cannot
provide all the answers you will need, but we believe it is a good starting point.
PEOPLE ARE ASKING
"Some newspaper ads for home loans show surprisingly
low rates. Are these loans for real, or is there a catch?"
Some of the ads you see are for adjustable rate mortgages
(Adjustable Rate Mortgages). These adjustable rate mortgage loans may
have low rates for a short time--maybe only for the first year. After that, the rates can
be adjusted on a regular basis. This means that the interest rate and the amount of the
monthly payment can go up or down.
"Will I know in advance how much my payment may go
With an adjustable-rate mortgage, your future monthly payment is
uncertain. Some types of Adjustable Rate Mortgages put a ceiling on your payment increase
or rate increase from one period to the next. Virtually all must put a ceiling on
interest-rate increases over the life of the loan.
"Is an Adjustable Rate Mortgage (Adjustable Rate
Mortgage) the right type of loan for me?"
That depends on your financial situation and the terms of the
Adjustable Rate Mortgage. Adjustable Rate Mortgages carry risks in periods of rising
interest rates, but can be cheaper over a longer term if interest rates decline. You will
be able to answer the question better once you understand more about adjustable-rate
mortgages. This booklet should help.
Mortgages have changed, and so have the questions that need to be
asked and answered.
Shopping for a mortgage used to be a relatively simple process. Most
home mortgage loans had interest rates that did not change over the life of the loan.
Choosing among these fixed-rate mortgage loans meant comparing interest rates, monthly
payments, fees, prepayment penalties, and due-on-sale clauses.
Today, many loans have interest rates (and monthly payments) that
can change from time to time. To compare one Adjustable Rate Mortgage with another or with
a fixed-rate mortgage, you need to know about indexes, margins, discounts, caps, negative
amortization, and convertibility. You need to consider the maximum amount your monthly
payment could increase. Most important, you need to compare what might happen to your
mortgage costs with your future ability to pay.
This booklet explains how Adjustable Rate Mortgages work and some of
the risks and advantages to borrowers that Adjustable Rate Mortgages introduce. It
discusses features that can help reduce the risks and gives some pointers about
advertising and other ways you can get information from lenders. Important Adjustable Rate
Mortgage terms are defined in a glossary on page 19. And a checklist at the end of the
booklet should help you ask lenders the right questions and figure out whether an
Adjustable Rate Mortgage is right for you. Asking lenders to fill out the checklist is a
good way to get the information you need to compare mortgages.
WHAT IS AN ADJUSTABLE RATE MORTGAGE (Adjustable Rate
With a fixed-rate mortgage, the interest rate stays the same during
the life of the loan. But with an Adjustable rate mortgage, the interest rate changes
periodically, usually in relation to an index, and payments may go up or down accordingly.
Lenders generally charge lower initial interest rates for Adjustable
Rate Mortgages than for fixed-rate mortgages. This makes the Adjustable Rate Mortgage
easier on your pocketbook at first than a fixed-rate mortgage for the same amount. It also
means that you might qualify for a larger loan because lenders sometimes make this
decision on the basis of your current income and the first year's payments. Moreover, your
Adjustable Rate Mortgage could be less expensive over a long period than a fixed-rate
mortgage--for example, if interest rates remain steady or move lower.
Against these advantages, you have to weigh the risk that an
increase in interest rates would lead to higher monthly payments in the future. It's a
trade-off--you get a lower rate with an Adjustable Rate Mortgage in exchange for assuming
Here are some questions you need to consider:
* Is my income likely to rise enough to cover higher mortgage
payments if interest rates go up?
* Will I be taking on other sizable debts, such as a loan for a car
or school tuition, in the near future?
* How long do I plan to own this home? (If you plan to sell soon,
rising interest rates may not pose the problem they do if you plan to own the house for a
* Can my payments increase even if interest rates generally do not
HOW Adjustable rate mortgages WORK: THE BASIC FEATURES
The Adjustment Period
With most Adjustable Rate Mortgages, the interest rate and monthly
payment change every year, every three years, or every five years. However, some
Adjustable Rate Mortgages have more frequent interest and payment changes. The period
between one rate change and the next is called the adjustment period. So, a loan with an
adjustment period of one year is called a one-year Adjustable Rate Mortgage, and the
interest rate can change once every year.
Most lenders tie Adjustable Rate Mortgage interest rate changes to
changes in an "index rate." These indexes usually go up and down with the
general movement of interest rates. If the index rate moves up, so does your mortgage rate
in most circumstances, and you will probably have to make higher monthly payments. On the
other hand, if the index rate goes down your monthly payment may go down.
Lenders base Adjustable Rate Mortgage rates on a variety of indexes.
Among the most common are the rates on one-, three-, or five-year Treasury securities.
Another common index is the national or regional average cost of funds to savings and loan
associations. A few lenders use their own cost of funds, over which--unlike other
indexes--they have some control. You should ask what index will be used and how often it
changes. Also ask how it has behaved in the past and where it is published.
To determine the interest rate on an Adjustable Rate Mortgage,
lenders add to the index rate a few percentage points called the "margin." The
amount of the margin can differ from one lender to another, but it is usually constant
over the life of the loan.
Let's say, for example, that you are comparing Adjustable Rate
Mortgages offered by two different lenders. Both Adjustable Rate Mortgages are for 30
years and an amount of $65,000. (All the examples used in this booklet are based on this
amount for a 30-year term. Note that the payment amounts shown here do not include items
like taxes or insurance.)
Both lenders use the one-year Treasury index. But the first lender
uses a 2% margin, and the second lender uses a 3% margin. Here is how that difference in
margin would affect your initial monthly payment.
In comparing Adjustable Rate Mortgages, look at both the index and
margin for each plan. Some indexes have higher average values, but they are usually used
with lower margins. Be sure to discuss the margin with your lender.
Some lenders offer initial Adjustable Rate Mortgage rates that are
lower than the sum of the index and the margin. Such rates, called discounted rates, are
often combined with large initial loan fees ("points") and with much higher
interest rates after the discount expires.
Very large discounts are often arranged by the seller. The seller
pays an amount to the lender so the lender can give you a lower rate and lower payments
early in the mortgage term. This arrangement is referred to as a "seller
buydown." The seller may increase the sales price of the home to cover the cost of
A lender may use a low initial rate to decide whether to approve
your loan, based on your ability to afford it. You should be careful to consider whether
you will be able to afford payments in later years when the discount expires and the rate
Here is how a discount might work. Let's assume the one-year
Adjustable Rate Mortgage rate (index rate plus margin) is at 10%. But your lender is
offering an 8% rate for the first year. With the 8% rate, your first year monthly payment
would be $476.95.
But don't forget that with a discounted Adjustable Rate Mortgage,
your low initial payment will probably not remain low for long, and that any savings
during the discount period may be made up during the life of the mortgage or be included
in the price of the house. In fact, if you buy a home using this kind of loan, you run the
Payment shock may occur if your mortgage payment rises very sharply
at the first adjustment. Let's see what happens in the second year with your discounted 8%
Adjustable Rate Mortgage.
As the example shows, even if the index rate stays the same, your
monthly payment would go up from $476.95 to $568.82 in the second year.
Suppose that the index rate increases 2% in one year and the
Adjustable Rate Mortgage rate rises to a level of 12%.
That's an increase of almost $200 in your monthly payment. You can
see what might happen if you choose an Adjustable Rate Mortgage impulsively because of a
low initial rate. You can protect yourself from increases this big by looking for a
mortgage with features, described next, which may reduce this risk.
HOW CAN I REDUCE MY RISK?
Besides an overall rate ceiling, most Adjustable Rate Mortgages also
have "caps" that protect borrowers from extreme increases in monthly payments.
Others allow borrowers to convert an Adjustable Rate Mortgage to a fixed-rate mortgage.
While these may offer real benefits, they may also cost more, or add special features,
such as negative amortization.
An interest-rate cap places a limit on the amount your interest rate
can increase. Interest caps come in two versions:
* Periodic caps, which limit the interest rate increase from one
adjustment period to the next; and
* Overall caps, which limit the interest-rate increase over the life
of the loan.
By law, virtually all Adjustable Rate Mortgages must have an overall
cap. Many have a periodic interest rate cap.
Let's suppose you have an Adjustable Rate Mortgage with a periodic
interest rate cap of 2%. At the first adjustment, the index rate goes up 3%. The example
shows what happens.
A drop in interest rates does not always lead to a drop in monthly
payments. In fact, with some Adjustable Rate Mortgages that have interest rate caps, your
payment amount may increase even though the index rate has stayed the same or declined.
This may happen after an interest rate cap has been holding your interest rate down below
the sum of the index plus margin.
Look below at the example where there was a periodic cap of 2% on
the Adjustable Rate Mortgage, and the index went up 3% at the first adjustment. If the
index stays the same in the third year, your rate would go up to 13%.
In general, the rate on your loan can go up at any scheduled
adjustment date when the index plus the margin is higher than the rate you are paying
before that adjustment. The next example shows how a 5% overall rate cap would affect your
Let's say that the index rate increases 1% in each of the first ten
years. With a 5% overall cap, your payment would never exceed $813.00--compared to the
$1,008.64 that it would have reached in the tenth year based on a 19% indexed rate.
Some Adjustable Rate Mortgages include payment caps, which limit
your monthly payment increase at the time of each adjustment, usually to a percentage of
the previous payment. In other words, with a 7«% payment cap, a payment of $100 could
increase to no more than $107.50 in the first adjustment period, and to no more than
$115.56 in the second.
Let's assume that your rate changes in the first year by 2
percentage points, but your payments can increase by no more than 7«% in any one year.
Here's what your payments would look like:
Many Adjustable Rate Mortgages with payment caps do not have
periodic interest rate caps.
If your Adjustable Rate Mortgage contains a payment cap, be sure to
find out about "negative amortization." Negative amortization means the mortgage
balance is increasing. This occurs whenever your monthly mortgage payments are not large
enough to pay all of the interest due on your mortgage.
Because payment caps limit only the amount of payment increases, and
not interest-rate increases, payments sometimes do not cover all of the interest due on
your loan. This means that the interest shortage in your payment is automatically added to
your debt, and interest may be charged on that amount. You might therefore owe the lender
more later in the loan term than you did at the start. However, an increase in the value
of your home may make up for the increase in what you owe.
The next illustration uses the figures from the preceding example to
show how negative amortization works during one year. Your first 12 payments of $570.42,
based on a 10% interest rate, paid the balance down to $64,638.72 at the end of the first
year. The rate goes up to 12% in the second year. But because of the 7«% payment cap,
payments are not high enough to cover all the interest. The interest shortage is added to
your debt (with interest on it), which produces negative amortization of $420.90 during
the second year.
To sum up, the payment cap limits increases in your monthly payment
by deferring some of the increase in interest. Eventually, you will have to repay the
higher remaining loan balance at the Adjustable Rate Mortgage rate then in effect. When
this happens, there may be a substantial increase in your monthly payment.
Some mortgages contain a cap on negative amortization. The cap
typically limits the total amount you can owe to 125% of the original loan amount. When
that point is reached, monthly payments may be set to fully repay the loan over the
remaining term, and your payment cap may not apply. You may limit negative amortization by
voluntarily increasing your monthly payment.
Be sure to discuss negative amortization with the lender to
understand how it will apply to your loan.
Prepayment and Conversion
If you get an Adjustable Rate Mortgage and your financial
circumstances change, you may decide that you don't want to risk any further changes in
the interest rate and payment amount. When you are considering an Adjustable Rate
Mortgage, ask for information about prepayment and conversion.
Prepayment. Some agreements may require you to pay special fees or
penalties if you pay off the Adjustable Rate Mortgage early. Many Adjustable Rate
Mortgages allow you to pay the loan in full or in part without penalty whenever the rate
is adjusted. Prepayment details are sometimes negotiable. If so, you may want to negotiate
for no penalty, or for as low a penalty as possible.
Conversion. Your agreement with the lender can have a clause that
lets you convert the Adjustable Rate Mortgage to a fixed-rate mortgage at designated
times. When you convert, the new rate is generally set at the current market rate for
The interest rate or up-front fees may be somewhat higher for a
convertible Adjustable Rate Mortgage. Also, a convertible Adjustable Rate Mortgage may
require a special fee at the time of conversion.
WHERE TO GET INFORMATION
Before you actually apply for a loan and pay a fee, ask for all the
information the lender has on the loan you are considering. It is important that you
understand index rates, margins, caps, and other Adjustable Rate Mortgage features like
negative amortization. You can get helpful information from advertisements and
disclosures, which are subject to certain federal standards.
Your first information about mortgages probably will come from
newspaper advertisements placed by builders, real estate brokers, and lenders. While this
information can be helpful, keep in mind that the ads are designed to make the mortgage
look as attractive as possible. These ads may play up low initial interest rates and
monthly payments, without emphasizing that those rates and payments later could increase
substantially. Get all the facts.
A federal law, the Truth in Lending Act, requires mortgage
advertisers, once they begin advertising specific terms, to give further information on
the loan. For example, if they want to show the interest rate or payment amount on the
loan, they must also tell you the annual percentage rate (APR) and whether that rate may
go up. The annual percentage rate, the cost of your credit as a yearly rate, reflects more
than just a low initial rate. It takes into account interest, points paid on the loan, any
loan origination fee, and any mortgage insurance premiums you may have to pay.
Disclosures From Lenders
Federal law requires the lender to give you information about
adjustable-rate mortgages, in most cases before you apply for a loan. The lender also is
required to give you information when you get a mortgage. You should get a written summary
of important terms and costs of the loan. Some of these are the finance charge, the annual
percentage rate, and the payment terms.
Selecting a mortgage may be the most important financial decision
you will make, and you are entitled to all the information you need to make the right
decision. Don't hesitate to ask questions about Adjustable Rate Mortgage features when you
talk to lenders, real estate brokers, sellers, and your attorney, and keep asking until
you get clear and complete answers. The checklist at the back of this pamphlet is intended
to help you compare terms on different loans.
Annual Percentage Rate (APR)
A measure of the cost of credit, expressed as a yearly rate. It
includes interest as well as other charges. Because all lenders follow the same rules to
ensure the accuracy of the annual percentage rate, it provides consumers with a good basis
for comparing the cost of loans, including mortgage plans.
Adjustable-Rate Mortgage (Adjustable Rate Mortgage)
A mortgage where the interest rate is not fixed, but changes during
the life of the loan in line with movements in an index rate. You may also see Adjustable
Rate Mortgages referred to as AMLs (adjustable mortgage loans) or VRMs (variable-rate
When a home is sold, the seller may be able to transfer the mortgage
to the new buyer. This means the mortgage is assumable. Lenders generally require a credit
review of the new borrower and may charge a fee for the assumption. Some mortgages contain
a due-on-sale clause, which means that the mortgage may not be transferable to a new
buyer. Instead, the lender may make you pay the entire balance that is due when you sell
the home. Assumability can help you attract buyers if you sell your home.
With a buydown, the seller pays an amount to the lender so that the
lender can give you a lower rate and lower payments, usually for an early period in an
Adjustable Rate Mortgage. The seller may increase the sales price to cover the cost of the
buydown. Buydowns can occur in all types of mortgages, not just Adjustable Rate Mortgages.
A limit on how much the interest rate or the monthly payment can
change, either at each adjustment or during the life of the mortgage. Payment caps don't
limit the amount of interest the lender is earning, so they may cause negative
A provision in some Adjustable Rate Mortgages that allows you to
change the Adjustable Rate Mortgage to a fixed-rate loan at some point during the term.
Usually conversion is allowed at the end of the first adjustment period. At the time of
the conversion, the new fixed rate is generally set at one of the rates then prevailing
for fixed rate mortgages. The conversion feature may be available at extra cost.
In an Adjustable Rate Mortgage with an initial rate discount, the
lender gives up a number of percentage points in interest to give you a lower rate and
lower payments for part of the mortgage term (usually for one year or less). After the
discount period, the Adjustable Rate Mortgage rate will probably go up depending on the
The index is the measure of interest rate changes that the lender
uses to decide how much the interest rate on an Adjustable Rate Mortgage will change over
time. No one can be sure when an index rate will go up or down. To help you get an idea of
how to compare different indexes, the following chart shows a few common indexes over a
ten-year period (1977-87). As you can see, some index rates tend to be higher than others,
and some more volatile. (But if a lender bases interest rate adjustments on the average
value of an index over time, your interest rate would not be as volatile.) You should ask
your lender how the index for any Adjustable Rate Mortgage you are considering has changed
in recent years, and where it is reported.
The number of percentage points the lender adds to the index rate to
calculate the Adjustable Rate Mortgage interest rate at each adjustment.
Amortization means that monthly payments are large enough to pay the
interest and reduce the principal on your mortgage. Negative amortization occurs when the
monthly payments do not cover all of the interest cost. The interest cost that isn't
covered is added to the unpaid principal balance. This means that even after making many
payments, you could owe more than you did at the beginning of the loan. Negative
amortization can occur when an Adjustable Rate Mortgage has a payment cap that results in
monthly payments not high enough to cover the interest due.
A point is equal to one percent of the principal amount of your
mortgage. For example, if you get a mortgage for $65,000, one point means you pay $650 to
the lender. Lenders frequently charge points in both fixed-rate and adjustable-rate
mortgages in order to increase the yield on the mortgage and to cover loan closing costs.
These points usually are collected at closing and may be paid by the borrower or the home
seller, or may be split between them.
Ask your lender to help fill out this checklist. Mortgage A Mortgage
Basic Features for Comparison
Fixed-rate annual percentage rate (the cost of your credit as a
yearly rate which includes both interest and other charges) __________ __________
Adjustable Rate Mortgage annual percentage rate __________
Adjustment period __________ __________
Index used and current rate __________ __________
Margin __________ __________
Initial payment without discount __________ __________
Initial payment with discount (if any) __________ __________
How long will discount last? __________ __________
Interest rate caps: periodic __________ __________
overall __________ __________
Payment caps __________ __________
Negative amortization __________ __________
Convertibility or prepayment privilege __________ __________
Initial fees and charges __________ __________
Monthly Payment Amounts
What will my monthly payment be after twelve months if the index
stays the same __________ __________
goes up 2% __________ __________
goes down 2% __________ __________
What will my monthly payments be after three years if the index
stays the same __________ __________
goes up 2% per year __________ __________
goes down 2% per year __________ __________
Take into account any caps on your mortgage and remember it may run
End of Handbook.
Learn how a FHA adjustable rate mortgage will affect
you for loan qualification by clicking
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with a free FHA adjustable rate mortgage
Download a .pdf copy of the *
Consumer Handbook on Adjustable Rate Mortgages here.