Reserve Boa

and the Off

Thrift Supe

sion prepar

this booklet 

adjustable-ra

mortgages (ARM

response to a request fr

the House Com mittee on Banking, Finan

and Urban Affairs (currently, the Commit

tee on Financial Services) and in consulta

with many other agencies and trade and 

sumer groups. It is designed to help cons

understand an important and complex m

gage option available to homebuyers.

We believe a fully informed consumer is 

the best position to make a sound econom

choice. If you are buying a home and look

ing for a home loan, this booklet will pro

useful basic information about ARMs. It c

provide all the answers you will need, bu

believe it is a good starting point.

armstext.indd 1 rmstext.indd 1 
eope ae asg 

“Some newspaper ads for home loans show surprisingly low 

these loans for real, or is there a catch?”

 Some of the ads you see are for adjustable rate mo

(ARMs). These loans may have low rates for a sho

maybe only for the first year. After that, the rates 

adjusted on a regular basis. This means that the i

the amount of the monthly payment may go up o

“Will I know in advance how much my payment may go up

 With an adjustable-rate mortgage, your future mo

is uncertain. Some types of ARMs put a ceiling o

increase or interest-rate increase from one period 

Virtually all types must put a ceiling on rate incr

life of the loan.

“Is an ARM the right type of loan for me?”

 That depends on your financial situation and the 

ARM. ARMs carry risks in periods of rising inter

they can be cheaper over a longer term if inter est 

You will be able to answer the question better on

stand more about ARMs. This booklet should hel

armstext.indd 2 rmstext.indd 2 
sumers need to ask and have answered.

 Shopping for a mortgage used to be a relatively s

Most home mort gage loans had interest rates tha

over the life of the loan. Choosing among these fi

gage loans meant comparing interest rates, month

fees, prepayment penalties, and due-on-sale clau

 Today, many loans have interest rates (and month

that can change from time to time. To compare on

another or with a fixed-rate mortgage, you need t

indexes, margins, discounts, caps, negative amor

convertibility. You need to consider the maximum 

monthly payment could increase. Most importan

compare what might happen to your mort gage co

future ability to pay.

 This booklet explains how ARMs work and some 

and advantages to borrowers that ARMs introdu

features that can help reduce the risks and gives 

about advertising and other ways you can get inf

lenders. Important ARM terms are defined in a g

19. And a checklist at the end of the booklet shou

lenders the right questions and figure out whethe

right for you. Asking lenders to fill out the check

way to get the information you need to compare 

armstext.indd 3 rmstext.indd 3 
as a

 With a fixed-rate mortgage, the interest rate stays 

during the life of the loan. But with an ARM, the 

changes periodically, usually in relation to an ind

ments may go up or down accordingly.

 Lenders generally charge lower initial interest ra

than for fixed-rate mortgages. This makes the AR

your pocketbook at first than a fixed-rate mortga

amount. It also means that you might qualify for 

because lenders sometimes make the decision ab

extend a loan on the basis of your current income 

year’s payments. Moreover, your ARM could be l

over a long period than a fixed-rate mortgage—fo

interest rates remain steady or move lower.

 Against these advantages, you have to weigh the 

increase in interest rates would lead to higher mo

ments in the future. It’s a trade-off—you get a low

ARM in exchange for assuming more risk.

 Here are some questions you need to consider:

■ Is my income likely to rise enough to cover h

payments if interest rates go up?

■ Will I be taking on other sizable debts, such a

car or school tuition, in the near future?

■ How long do I plan to own this home? (If you 

soon, rising interest rates may not pose the p

if you plan to own the house for a long time.)

■ Can my payments increase even if in terest ra

do not increase?

armstext.indd 4 rmstext.indd 4 
os o

the Basic Features

The adjustment period

 With most ARMs, the interest rate and monthly p

every year, every three years, or every five years. 

some ARMs have more frequent rate and paymen

The period between one rate change and the next 

“adjustment period.” A loan with an adjustment 

year is called a one-year ARM, and the interest ra

once every year.

The index

 Most lenders tie ARM interest-rate changes to ch

“index rate.” These in dexes usually go up and do

general movement of interest rates. If the index ra

so does your mortgage rate in most circumstance

probably have to make higher monthly payments

hand, if the index rate goes down, your monthly 

go down.

 Lenders base ARM rates on a variety of indexes. 

most common indexes are the rates on one-, three

Treasury securities. Another common index is th

regional average cost of funds to savings and loa

A few lenders use their own cost of funds as an i

gives them more control than using other indexe

ask what index will be used and how often it cha

how it has fluctuated in the past and where it is p

armstext.indd 5 rmstext.indd 5 
 To determine the interest rate on an ARM, lender

index rate a few percent age points, called the “m

amount of the margin may differ from one lende

it is usually constant over the life of the loan.

Index rate + margin =

ARM interest rate

 Let’s say, for example, that you are com paring AR

two different lenders. Both ARMs are for 30 year

loan amount of $65,000. (All the examples used in 

are based on this amount for a 30-year term. Not

ment amounts shown here do not include taxes, i

similar items.)

 Both lenders use the rate on one-year Treasury se

index. But the first lender uses a 2% mar gin, and 

lender uses a 3% mar gin. Here is how that differe

margin would affect your initial monthly payme

 In comparing ARMs, look at both the index and m

program. Some indexes have higher values, but t

used with lower margins. Be sure to discuss the m

your lender.

armstext.indd 6 rmstext.indd 6 
Home sale price $ 85,00

Less down payment - 20,00

Mortgage amount $ 65,00

Mortgage term 30 years

FIRST LENDER

One-year index = 8%

Margin = 2%

ARM interest rate = 10%

Monthly payment @ 10 % = $ 570.4

SECOND LENDER

One-year index = 8%

Margin = 3%

ARM interest rate = 11%

Monthly payment @ 11% = $ 619.0

armstext.indd 7 rmstext.indd 7 
CosueCauos 

Discounts 

 Some lenders offer initial ARM rates that are low

“standard” ARM rates (that is, lower than the sum 

and the margin). Such rates, called discounted ra

combined with large initial loan fees (“points”) a

higher rates after the discount expires.

 Very large discounts are often arranged by the se

pays an amount to the lender so that the lender c

lower rate and lower payments early in the mortg

arrangement is re ferred to as a “seller buydown.” 

increase the sales price of the home to cover the c

down.

 A lender may use a low initial rate to de cide whe

your loan, based on your ability to afford it. You 

ful to consider whether you will be able to afford 

later years when the discount expires and the rat

 Here is how a discount might work. Let’s assume 

er’s “standard” one-year ARM rate (index rate plu

currently 10%. But your lender is offering an 8% 

year. With the 8% rate, your first-year monthly pa

be $476.95.

 But don’t forget that with a discounted ARM, you

ment will prob ably remain at $476.95 for only 12 

that any savings during the discount period may 

during the life of the mortgage or may be include

of the house. In fact, if you buy a home using this 

you run the risk of . . .

armstext.indd 8 rmstext.indd 8 
 Payment shock may occur if your mortgage paym

sharply at the first ad just ment. Let’s see what wo

the sec ond year if the rate on your discounted 8% 

rise to the 10% “standard” rate.

 As the example shows, even if the index rate wer

same, your monthly payment would go up from 

$568.82 in the second year.

 Suppose that the index rate increases 2% in one y

ARM rate rises to 12%.

 That’s an increase of almost $200 in your monthly 

can see what might happen if you choose an ARM 

low initial rate. You can pro tect yourself from lar

looking for a mortgage with features, described n

reduce this risk.

ARM Interest Rate Monthly 

1st year (w/discount) @ 8% $ 476.9

2nd year @ 12% $ 665.4

ARM Interst Rate Monthly 

1st year (w/discount) @ 8% $ 476.9

2nd year @ 10% $ 568.8

armstext.indd 9 rmstext.indd 9 
oCaeduce y s

 Besides offering an overall rate ceiling, most ARM

“caps” that protect borrowers from extreme incre

pay ments. Others allow borrowers to convert an 

rate mortgage. While they may offer real benefits

may also cost more, or may add special features s

amortization.

Interest-rate caps 

 An interest-rate cap places a limit on the amount 

rate can increase. Interest caps come in two versio

■ Periodic caps, which limit the interest rate inc

adjustment period to the next; and

■ Overall caps, which limit the interest-rate inc

life of the loan.

 By law, virtually all ARMs must have an overall c

a periodic cap.

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

of 2%. At the first adjustment, the index rate goes 

example shows what happens.

ARM Interest Rate Monthly 

1st year @ 10% $ 570.4

2nd year @ 13% (without cap) $ 717.12

2nd year @ 12% (with cap) $ 667.3

Difference in 2nd year between payment 

and payment without = $ 49.82

armstext.indd 10 rmstext.indd 10 
monthly payments. In fact, with some ARMs that 

est-rate caps, your payment amount may increase 

the index rate has stayed the same or declined. T

pen when an interest-rate cap has been holding y

rate down below the sum of the index plus margi

holds down your interest rate, increases to the in

not imposed because of the cap may carry over to 

adjustments.

With some ARMs, payments

may increase even if the index

rate stays the same or declines.

 The following example shows how carryovers wo

increased 3% during the first year. Because this A

increases to 2% at any one time, the rate is adjust

to 12% for the second year. However, the remaini

in the index carries over to the next time the lend

rates. So when the lender adjusts the interest rate 

year, the rate increases 1%, to 13%, even though t

change in the index during the second year.

ARM Interest Rate Month

1st year @ 10% $ 570.4

If index rises 3% . . .

2nd year @ 12% (with 2% rate cap) $ 667.3

If index stays the same

for the 3rd year @ 13% $ 716.5

Even though the index stays the 

same in 3rd year, payment goes up $ 49.2

armstext.indd 11 rmstext.indd 11 
adjustment date when the lenders standard ARM 

plus the margin) is higher than the rate you are p

that adjustment. 

 The next example shows how a 5% overall rate ca

your loan.

 Let’s say that the index rate increases 1% in each 

years. With a 5% overall cap, your payment woul

$813.00—compared to the 1,008.64 that it would h

the tenth year based on a 19% interest rate.

Payment caps

 Some ARMs include payment caps, which limit y

payment increase at the time of each adjustment, 

a per centage of the previous payment. In other w

71⁄2% payment cap, a pay ment of $100 could incre

than $107.50 in the first adjustment period, and to 

$115.56 in the second.

ARM Interest Rate Monthly 

1st year @ 10% $ 570.42

 

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

armstext.indd 12 rmstext.indd 12 
centage points but your payments can increase by 

71⁄2% in any one year. 

 Here’s what your payments would look like:

 Many ARMs with payment caps do not have peri

rate caps.

Negative amortization

 If your ARM includes a payment cap, be sure to f

“negative amortiza tion.” Negative amortization m

mortgage balance increases. It occurs whenever y

mortgage payments are not large enough to pay a

est due on your mortgage.

ARM Interest Rate Monthly 

1st 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

armstext.indd 13 rmstext.indd 13 
increases, and not interestrate increases, paymen

do not cover all the interest due on your loan. Th

the interest shortage in your payment is automat

to your debt, and interest may be charged on that 

might therefore owe the lender more later in the l

you did at the start. However, an increase in the v

home may make up for the increase in what you 

 The next illustration uses the figures from the pr

ple to show how negative amortization works du

Your first 12 payments of $570.42, based on a 10% 

paid the bal ance down to $64,638.72 at the end of 

 The rate goes up to 12% in the second year. But b

71⁄2% pay ment cap, your payments are not high en

all the interest. The interest shortage is added to y

Beginning loan amount = $ 65,000

Loan amount at end of 1st year = 

$ 64,638.72

Negative amortization during 2nd ye

$ 420.90

Loan amount at end of 2nd year = 

$ 65,059.62 ($ 64,638.72 + $ 420.

(If you sold your house at this point, 

would owe almost $60 more than yo

originally borrowed)

armstext.indd 14 rmstext.indd 14 
during the second year.

 To sum up, the payment cap limits in creases in yo

payment by defer ring some of the increase in inte

tually, you will have to repay the higher remainin

at the ARM rate then in effect. When this happen

a substantial increase in your monthly payment.

 Some mortgages include a cap on nega tive amort

cap typically limits the total amount you can owe 

the original loan amount. When that point is rea

payments may be set to fully repay the loan over 

ing term, and your payment cap may not apply. Y

negative amortization by voluntarily increasing y

payment.

 Be sure to discuss negative amortization with the 

understand how it will apply to your loan.

Prepayment and conversion 

 If you get an ARM and your financial cir cumstan

you may decide that you don’t want to risk any fu

in the interest rate and payment amount. When y

sidering an ARM, ask for information about prep

conversion.

Prepayment. Some agreements may re quire you 

fees or penalties if you pay off the ARM early. Ma

allow you to pay the loan in full or in part withou

whenever the rate is ad justed. Prepayment details 

negotiable. If so, you may want to negotiate for no 

as low a penalty as possible.

armstext.indd 15 rmstext.indd 15 
clause that lets you con vert the ARM to a fixed-ra

designated times. When you convert, the new rat

set at the current market rate for fixed-rate mortg

 The interest rate or up-front fees may be somewh

convertible ARM. Also, a convertible ARM may r

fee at the time of conversion.

armstext.indd 16 rmstext.indd 16 
ee o Geoao

 Before you actually apply for a loan and pay a fee

information the lender has on the loan you are co

important that you understand index rates, marg

other ARM features such as negative amortizatio

helpful information from advertisements and dis 

are subject to certain federal standards.

Advertising 

 Your first information about mortgages prob ably 

from newspaper advertise ments placed by builde

brokers, and lenders. Although this information 

keep in mind that the ads are designed to make t

look as at tractive as possible. These ads may play 

interest rates and monthly payments, without em

those rates and payments later could increase sub

get all the facts.

 A federal law, the Truth in Lending Act, requires 

advertisers, once they be gin advertising specific 

further information on the loan. For example, if t

show the interest rate or payment amount on the 

also tell you the annual percentage rate (APR) an

rate may go up. The APR, the cost of your credit a

reflects more than just a low initial rate. It takes i

interest, points paid on the loan, any loan origina

any mortgage insurance premiums you may have 

Ads may play up low initial ra

Get all the facts.

armstext.indd 17 rmstext.indd 17 
 Federal law requires the lender to give you inform

ARMs, in most cases before you apply for a loan. 

is required to give you infor mation when you ap

gage. You should get a written summary of impo

costs of the loan. Some of these are the finance ch

and the payment terms.

Read information from lenders — 

ask questions — before committing 

 Selecting a mortgage may be the most important 

decision you will make, and you are entitled to a

tion you need to make the right decision. Don’t h

questions about ARM fea tures when you talk to l

estate brokers, sellers, and your attorney, and kee

you get clear and complete an swers. The checklis

this booklet is intended to help you compare term

loans.

armstext.indd 18 rmstext.indd 18 
y

Adjustable-rate mortgage (ARM) 

 A mortgage for which the interest rate is not fixed

during the life of the loan in line with movement

rate. You may also see ARMs referred to as AML

mortgage loans) or VRMs (variable-rate mortgage

Annual percentage rate (APR)

 A measure of the cost of credit, expressed as a ye

includes interest as well as other charges. Becaus

follow the same rules when calculating the APR, 

con sumers with a good basis for comparing the c

including mortgages.

Buydown

 With a buydown, the seller pays an amount to th

that the lender can give you a lower rate and lowe

usually for an early period in an ARM. The seller 

the sales price to cover the cost of the buydown. B

occur in all types of mortgages, not just ARMs.

Cap

 A limit on how much the interest rate or the mon

may change, either at each adjustment or during 

mortgage. Payment caps don’t limit the amount o

lender is earning, so they may cause negative am

Conversion clause

 A provision in some ARMs that allows you to ch

to a fixed-rate loan at some point during the term

usually allowed at the end of the first ad justment 

time of the conver sion, the new fixed rate is gene

of the rates then prevailing for fixed -rate mortgag

sion feature may be available at extra cost.

armstext.indd 19 rmstext.indd 19 
 In an ARM with an initial rate discount, the lend

number of percentage points in interest to give yo

and lower payments for part of the mort gage term 

one year or less). After the discount period, the A

probably go up depending on the index rate.

Index

 The index is the measure of interest-rate changes 

uses to decide how much the interest rate on an A

change over time. No one can be sure when an in

up or down. To help you get an idea of how to co

indexes, the following chart shows a few commo

an eleven-year period (1994-2004). As you can see

rates tend to be higher than others, and some mo

if a lender bases interest-rate adjustments on the 

1-year

Treasury Rate

National Average Mortgage

Contract Interest Rate

SELECTED INDEX RATES FOR ARMs

OVER AN ELEVEN-YEAR PERIOD

Cost of Funds

for Savings and

Loan Associations

1994 1996 1998 2000 2002 2

armstext.indd 20 rmstext.indd 20 
You should ask your lender how the index for any 

considering has changed in recent years, and wh

reported.

Margin

 The number of percentage points the lender adds 

rate to calculate the ARM interest rate at each adj

Negative Amortization

 Amortization means that monthly payments are 

to pay the interest and reduce the principal on yo

Negative amortization occurs when the monthly 

not cover all the interest cost. The interest cost th

is added to the unpaid principal balance. This me

after making many payments, you could owe mo

at the beginning of the loan. Negative amortizati

when an ARM has a payment cap that results in m

ments not high enough to cover the interest due.

Points 

 One point is equal to 1 percent of the principal am

mortgage. For example, if the mortgage is for $65

equals $650. Lenders frequently charge points in 

and adjustable-rate mortgages in order to increas

the mortgage and to cover loan closing costs. The

ally are collected at closing and may be paid by t

the home seller, or may be split between them.

armstext.indd 21 rmstext.indd 21 
 Mortgage A 

Mortgage amount ____________ 

Basic Features for Comparison

Fixed-rate annual percentage rate

(the cost of your credit as a yearly

rate, including 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 ____________ 

armstext.indd 22 rmstext.indd 22 
 Mortgage A 

Mortgage amount ____________ 

Monthly Payment Amounts 

What will my monthly payment be

after 12 months if the index rate:

 stays the same ____________ 

 goes up 2% ____________ 

 goes down 2% ____________ 

What will my monthly payment be

after 3 years if the index rate:

 stays the same ____________ 

 goes up 2% per year ____________ 

 goes down 2% per year ____________ 

Take into account any caps on your mortgage and remem

run 30 years.

armstext.indd 23 rmstext.indd 23 
organizations:

American Bankers Association

America’s Community Bankers

 (formerly the National Council of Savings Institutions a

 U.S. League of Savings Institutions)

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 Credit Union Administration

Office of Special Advisor to the President for Consumer A

The Consumer Bankers Association

U.S. Department of Housing and Urban Development

With special thanks to Fannie Mae and Freddie Mac.

Revised: 2005 Reprinted: May 2005 100,000

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