The Federal
Reserve Board and the Office of Thrift
Supervision prepared this information on
adjustablerate mortgages (ARMs) in
response to a request from the House
Committee on Banking, Finance, and
Urban Affairs (currently, the Committee
on Financial Services) 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 homebuyers.
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 adjustablerate
mortgages (ARMs). These loans may have
low rates for a short timemaybe only
for the first year. After that, the
rates may be adjusted on a regular
basis. This means that the interest rate
and the amount of the monthly payment
may go up or down.
“Will I know in advance how much my
payment may go up?”
With an
adjustablerate mortgage, your future
monthly payment is uncertain. Some types
of ARMs put a ceiling on your payment
increase or interestrate increase from
one period to the next. Virtually all
types must put a ceiling on rate
increases over the life of the loan.
“Is
an ARM the right type of loan for me?”
That depends on
your financial situation and the terms
of the ARM. ARMs carry risks in periods
of rising interest rates, but they 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 ARMs. This
booklet should help.
Mortgages have
changed, and so have the questions that
consumers need to ask and have 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 fixedrate mortgage loans meant
comparing interest rates, monthly
payments, fees, prepayment penalties,
and dueonsale clauses.
Today, many
loans have interest rates (and monthly
payments) that can change from time to
time. To compare one ARM with another or
with a fixedrate 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 web page
explains how ARMs work and some of the
risks and advantages to borrowers that
ARMs 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 ARM terms are defined
in a
glossary. And the
checklist at the end of the booklet
should help you ask lenders the right
questions and figure out whether an ARM
is right for you. Asking lenders to fill
out the checklist is a good way to get
the information you need to compare
mortgages.
Back to top
What is an ARM?
With a
fixedrate mortgage, the interest rate
stays the same during the life of the
loan. But with an ARM, 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 ARMs than for fixedrate
mortgages. This makes the ARM easier on
your pocketbook at first than a
fixedrate mortgage for the same amount.
It also means that you might qualify for
a larger loan because lenders sometimes
make the decision about whether to
extend a loan on the basis of your
current income and the first year’s
payments. Moreover, your ARM could be
less expensive over a long period than
a fixedrate mortgagefor 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 tradeoffyou get a
lower rate with an ARM in exchange for
assuming more risk.
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 long time.) 

Can my
payments increase even if
interest rates generally do not
increase? 
How
ARMs Work: the Basic Features
The
adjustment period
With most ARMs,
the interest rate and monthly payment
change every year, every three years, or
every five years. However, some ARMs
have more frequent rate and payment
changes. The period between one rate
change and the next is called the
“adjustment period.” A loan with an
adjustment period of one year is called
a oneyear ARM, and the interest rate
can change once every year.
The
index
Most lenders tie
ARM interestrate 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 ARM
rates on a variety of indexes. Among the
most common indexes are the rates on
one, three, or fiveyear 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 as an index, which gives them more
control than using other indexes. You
should ask what index will be used and
how often it changes. Also ask how it
has fluctuated in the past and where it
is published.
The
margin
To determine the
interest rate on an ARM, lenders add to
the index rate a few percentage points,
called the “margin.” The amount of the
margin may differ from one lender to
another, but it is usually constant over
the life of the loan.
Index rate + margin = ARM interest
rate
Let’s say, for
example, that you are comparing ARMs
offered by two different lenders. Both
ARMs are for 30 years and have a loan
amount of $65,000. (All the examples
used in this booklet are based on this
amount for a 30year term. Note that the
payment amounts shown here do not
include taxes, insurance, or similar
items.)
Both lenders use
the rate on oneyear Treasury securities
as the index. But the first lender uses
a 2% margin, and the second lender uses
a 3% margin. Here is how that
difference in the margin would affect
your initial monthly payment.
In comparing
ARMs, look at both the index and margin
for each program. Some indexes have
higher values, but they are usually used
with lower margins. Be sure to discuss
the margin with your lender.

Home sale
price 
$ 85.000 


Less down
payment 
 $ 20.000 


Mortgage
amount 
= $ 65.000 


Mortgage
term 30 years 


FIRST
LENDER 


Oneyear
index = 8% 


Margin = 2% 


ARM
interest rate = 10% 


Monthly
payment @ 10% = 
$ 570.42 


SECOND
LENDER 


Oneyear
index = 8% 


Margin = 3% 


ARM
interest rate = 11% 


Monthly
payment @ 11% 
$ 619.01 

Back to top
Consumer Cautions
Discounts
Some lenders
offer initial ARM rates that are lower
than their “standard” ARM rates (that
is, 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 rates after the
discount expires.
Very large
discounts are often arranged by the
seller. The seller pays an amount to the
lender so that 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 the
buydown.
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 is
adjusted. Here is how a discount might
work. Let’s assume that the lender’s
“standard” oneyear ARM rate (index rate
plus margin) is currently 10%. But your
lender is offering an 8% rate for the
first year. With the 8% rate, your
firstyear monthly payment would be
$476.95.
But don’t forget
that with a discounted ARM, your initial
payment will probably remain at $476.95
for only 12 monthsand that any savings
during the discount period may be made
up during the life of the mortgage or
may be included in the price of the
house. In fact, if you buy a home using
this kind of loan, you run the risk of .
. .
Payment shock
Payment shock
may occur if your mortgage payment rises
very sharply at the first adjustment.
Let’s see what would happen in the
second year if the rate on your
discounted 8% ARM were to rise to the
10% “standard” rate.

ARM
Interest Rate 
Monthly
Payment 


1st year
(w/discount) @ 8% 
$ 476.95 


2nd year @
10% 
$ 568.82 

As the example
shows, even if the index rate were to
stay 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 ARM rate rises to 12%.

ARM
Interest Rate 
Monthly
Payment 


1st year
(w/discount) @ 8% 
$ 476.95 


2nd year @
12% 
$ 665.43 

That’s an
increase of almost $200 in your monthly
payment. You can see what might happen
if you choose an ARM because of a low
initial rate. You can protect yourself
from large increases by looking for a
mortgage with features, described next,
that may reduce this risk.
Back to top
How Can I Reduce My Risk?
Besides offering
an overall rate ceiling, most ARMs also
have “caps” that protect borrowers from
extreme increases in monthly payments.
Others allow borrowers to convert an ARM
to a fixedrate mortgage. While they may
offer real benefits, these ARMs may also
cost more, or may add special features
such as negative amortization.
Interestrate caps
An
interestrate cap places a limit
on the amount your interest rate
can increase. Interest caps come
in two versions: 

Periodic
caps, which limit the
interestrate increase from one
adjustment period to the next;
and 

Overall
caps, which limit the
interestrate increase over the
life of the loan. 
By law,
virtually all ARMs must have an overall
cap. Many have a periodic cap.
Let’s suppose
you have an ARM with a periodic
interestrate cap of 2%. At the first
adjustment, the index rate goes up 3%.
The example shows what happens.

ARM
Interest Rate 
Monthly
Payment 


1st year @
10% 
$ 570.42 


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


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


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

A drop in
interest rates does not always lead to a
drop in monthly payments. In fact, with
some ARMs that have interestrate caps,
your payment amount may increase even
though the index rate has stayed the
same or declined. This may happen when
an interestrate cap has been holding
your interest rate down below the sum of
the index plus margin. If a rate cap
holds down your interest rate, increases
to the index that were not imposed
because of the cap may carry over to
future rate adjustments.
With some ARMs, payments may
increase even if
the index rate stays the same or
declines.
The following
example shows how carryovers work. The
index increased 3% during the first
year. Because this ARM limits rate
increases to 2% at any one time, the
rate is adjusted by only 2%, to 12% 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, the
rate increases 1%, to 13%, even though
there is no change in the index during
the second year.

ARM
Interest Rate 
Monthly
Payment 


1st year @
10% 
$ 570.42 


If index
rises 3% . . .
2nd year @ 12% (with 2% rate
cap) 
$ 667.30 


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


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

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.
The next example
shows how a 5% overall rate cap would
affect your loan.

ARM
Interest Rate 
Monthly
payment 


1st year @
10% 
$ 570.42 


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

Let’s say that
the index rate increases 1% in each of
the next nine 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% interest rate.
Payment caps
Some ARMs
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 7½% 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 7½% in any
one year.
Here’s what your
payments would look like:

ARM
Interest Rate 
Monthly
payment 


1st year @
10% 
$ 570.42 


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


2nd year @
12%
(with 7½% payment cap) 
$ 613.20 


Difference
in monthly
payment = 
$ 54.10 

Many ARMs with
payment caps do not have periodic
interestrate caps.
Negative amortization
If your ARM
includes a payment cap, be sure to find
out about “negative amortization.”
Negative amortization means that the
mortgage balance increases. It 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 interestrate
increases, payments sometimes do not
cover all 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 7½% payment cap, your 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.

Beginning
loan amount = $65,000 


Loan amount
at end of 1st year = $ 64,638.72
Negative
amortization during 2nd year = $
420.90
Loan amount
at end of 2nd year = $ 65,059.62
($ 64,638.72 + $ 420.90)
(If you
sold your house at this point,
you would owe almost $60 more
than you originally borrowed) 

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 ARM rate
then in effect. When this happens, there
may be a substantial increase in your
monthly payment.
Some mortgages
include a cap on negative amortization.
The cap typically limits the total
amount you can owe to 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
ARM 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 ARM, ask for
information about prepayment and
conversion.
Prepayment. Some agreements may
require you to pay special fees or
penalties if you pay off the ARM early.
Many ARMs 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 may include a clause that
lets you convert the ARM to a
fixedrate mortgage at designated times.
When you convert, the new rate is
generally set at the current market rate
for fixedrate mortgages.
The interest
rate or upfront fees may be somewhat
higher for a convertible ARM. Also, a
convertible ARM may require a special
fee at the time of conversion.
