Examples in This Handbook

All examples in this handbook are based on a $200,000 loan amount and a 30-year term. Payment amounts in the examples do not include taxes, insurance, condominium or home-owner association fees, or similar items. These amounts can be a significant part of your monthly payment.

For a $200,000 loan, the first year’s monthly payment at 6 percent is $1,199.10. The second year’s monthly payment at 9 percent, without a periodic adjustment cap, is $1,600.42. The second year’s monthly payment at 8 percent, with a periodic adjustment cap, is $1,461.72. The difference in the second year between the payment with the cap and the payment without the cap is $138.70 per month.

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.

Some adjustable rate mortgages allow a larger rate change at the first adjustment and 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 adjustable rate mortgages 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. This is called carryover. So at the next adjustment date, your payment might increase even though the index rate has stayed the same or declined.

The following example shows how carryovers work. Suppose the index on your adjustable rate mortgage increased 3% during the first year. Because this adjustable rate mortgage 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, the rate increases by 1%, to 9%, even if there is no change in the index during the second year.

For a $200,000 loan, the first year’s monthly payment at 6 percent is $1,199.10. If the index rises 3 percent to 9 percent, but there is a 2 percent rate cap that limits the interest to 8 percent, the second year’s payments would be $1,461.72. If the index stays the same at 9 percent for the third year, the monthly payments in year 3 would be $1,597.84.

In general, the rate on your loan can go up at any scheduled adjustment date when the lender’s standard adjustable rate mortgage rate (the index plus the margin) is higher than the rate you are paying before that adjustment.

Lifetime caps

The next example shows how a lifetime rate cap would affect your loan. Let’s say that your adjustable rate mortgage 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.

For a $200,000 loan, the first year’s monthly payment at 6 percent is $1,199.10. With a lifetime cap, if the interest rate rose one percent per year over the next 9 years, and reached the lifetime cap of 12 percent, in year 10 the monthly payments would be $1,998.84. However, without a lifetime cap, if the interest rate rose one percent per year over the next 9 years, in year 10 the interest rate would be 15 percent and the monthly payments would be $2,409.11.

Payment caps

In addition to interest-rate caps, many adjustable rate mortgages--including payment-option adjustable rate mortgages--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 negative amortization.)

Let’s assume that your rate changes in the first year by 2 percentage points but your payments can increase no more than 7½% in any one year. The following graph shows what your monthly payments would look like.

For a $200,000 loan, the first year’s monthly payment at 6 percent is $1,199.10. If the interest rate rose two percent to 8 percent in the second year but there was a seven and one-half percent payment cap, monthly payments in the second year would be $1,289.03. If the interest rate rose two percent to 8 percent but there was no payment cap, monthly payments in the second year would be $1,461.72. The difference in the monthly payments with and without the payment cap is $172.69.

While your monthly payment will be only $1,289.03 for the second year, the difference of $172.69 each month will be added to the balance of your loan and will lead to negative amortization.

Some adjustable rate mortgages with payment caps do not have periodic interest-rate caps. In addition, as explained below, most payment-option adjustable rate mortgages have a built-in recalculation period, usually every 5 years. At that point, your payment will be recalculated (lenders use the term 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. 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 adjustable rate mortgages

Hybrid adjustable rate mortgages

Hybrid adjustable rate mortgages often are advertised as 3/1 or 5/1 adjustable rate mortgages--you might also see ads for 7/1 or 10/1 adjustable rate mortgages. These loans are a mix--or a hybrid--of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first few years of these loans--for example, for 5 years in a 5/1 adjustable rate mortgage. After that, the rate may adjust annually (the 1 in the 5/1 example), until the loan is paid off. In the case of 3/1 or 5/1 adjustable rate mortgages

• the first number tells you how long the fixed interest-rate period will be and
• the second number tells you how often the rate will adjust after the initial period.

You may also see ads for 2/28 or 3/27 adjustable rate mortgages--the first number tells you how long the fixed interest-rate period will be, 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.

Interest-only adjustable rate mortgages

An interest-only (I-O) adjustable rate mortgage payment plan allows you to pay only the interest for a specified number of years, typically between 3 and 10 years. This allows you to have smaller monthly payments for a period of time. After that, your monthly payment will increase--even if 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 payments increase after year 5, even if the rate stays the same. Keep in mind that the longer the I-O period, the higher your monthly payments will be after the I-O period ends.

For a $200,000 loan, the first year’s monthly payment at 6 percent for an interest-only loan is $1,000. The monthly payment in year 6 at 6 percent for principal and interest is $1,228.60. The monthly payment in year 6 at 8 percent interest for principal and interest is $1,543.63.

Payment-option adjustable rate mortgages

A payment-option adjustable rate mortgage is an adjustable-rate mortgage that allows you to choose among several payment options each month. The options typically include the following:

• a traditional payment of principal and interest, which reduces 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.
• an interest-only payment, which pays the interest but does not reduce the amount you owe on your mortgage as you make your payments.
• a minimum (or limited) payment that may be less than the 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 added to the principal of the loan, increasing the amount you owe and your future monthly payments, and increasing 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 at the end of the loan term, called a balloon payment.

The interest rate on a payment-option adjustable rate mortgage is typically very low for the first few months (for example, 2% for the first 1 to 3 months). After that, the interest rate usually rises to a rate closer to that of other mortgage loans. Your payments during the first 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, and your loan balance increases. This is called negative amortization. This means that even after making many payments, you 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 adjustable rate mortgages have a built-in recalculation period, usually every 5 years. At this point, your payment will be recalculated (lenders use the term 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 off the loan over the remaining term. It is likely that your payments would go up substantially.

More information on interest-only and payment-option adjustable rate mortgages is available in the Federal Reserve Board’s brochure titled Interest-Only Mortgage Payments and Payment-Option adjustable rate mortgages--Are They for You?

Consumer Cautions

Discounted interest rates

Many lenders offer more than one type of adjustable rate mortgage. Some lenders offer an adjustable rate mortgage with an initial rate that is lower than their fully indexed adjustable rate mortgage rate (that is, lower than the sum of the index plus the margin). Such rates--called discounted rates, start rates, or teaser rates--are often combined with large initial loan fees, sometimes called points, and with higher rates after the initial discounted rate expires.

Your lender or broker may offer you a choice of loans that may 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 first adjustment.

If a lender offers you a loan with a discount rate, don’t assume that means that the loan is a good one for you. You should carefully consider whether you will be able to afford higher payments 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 one-year adjustable rate mortgage rate (index rate plus margin) is currently 6%; the monthly payment for the first year would be $1,199.10. But your lender is offering an adjustable rate mortgage with a discounted initial rate of 4% for the first year. With the 4% rate, your first-year’s monthly payment would be $954.83.

With a discounted adjustable rate mortgage, your initial payment will probably remain at $954.83 for only a limited time--and any savings during the discount period may be offset by higher payments over the remaining life of the mortgage. If you are considering a discount adjustable rate mortgage, be sure to compare future payments with those for a fully indexed adjustable rate mortgage. In fact, if you buy a home or refinance using a deeply discounted initial rate, you run the risk of payment shock, negative amortization, or prepayment penalties or conversion fees.

Payment shock

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% adjustable rate mortgage were to rise to the 6% fully indexed rate.

For a $200,000 loan, the first year’s monthly payment at a discounted initial rate of 4 percent is $954.83. If the interest rate rose two percent to 6 percent in the second year, monthly payments in the second year would be $1,192.63. If the interest rate rose to 7 percent in the second year, monthly payments would be $1,320.59.

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 one year and the adjustable rate mortgage 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 adjustable rate mortgage because of a low initial rate without considering whether you will be able to afford future payments.

If you have an interest-only adjustable rate mortgage, payment shock can also occur when the interest-only period ends. Or, if you have a payment-option adjustable rate mortgage, payment shock can happen when the loan is recast.

The following example compares several different loans over the first 7 years of their terms; the payments shown are for years 1, 6, 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, adjustable rate mortgage payments can change quite a bit over the life of the loan--so while you could save money in the first few years of an adjustable rate mortgage, you could also face much higher payments in the future.

This example shows monthly payments for four different kinds of mortgages in years 1, 6, and 7 of the mortgage. For a 30-year fixed rate mortgage, the monthly payment of $1,199.10 stays the same across all years. For a five one A R M, the payments are $954.83 in year one, $1,165.51 in year 6, and $1,389.51 in year 7. For a five one interest only A R M, the payments are $666.68 in year one, $1,288.60 in year 6 and $1,536.29 in year 7. For a payment-option mortgage, the payments are $739.24 in year one, $1,603.10 in year 6, and $1,708.22 in year 7."

Negative amortization--When you owe more money than you borrowed

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--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 payment-option mortgage or because your loan has a payment cap.

For example, suppose you have a $200,000, 30-year payment-option adjustable rate mortgage with a 2% rate for the first 3 months and a 6% rate for the remaining 9 months of the year. Your minimum payment for the year is $739.24, as shown in the graph above. 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 on this loan, your loan balance at the end of the first year 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 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 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 adjustable rate mortgage you are considering can have negative amortization.

Home Prices, Home Equity, and adjustable rate mortgages

Sometimes home prices rise rapidly, allowing people to quickly build equity in their homes. This can make some people think that even if the rate and payments on their adjustable rate mortgage get too high, they can avoid those higher payments by refinancing their loan or, in the worst case, selling their home. It’s important to remember that home prices do not always go up quickly--they may increase a little or remain the same, and sometimes they fall. If housing prices fall, your home may not be worth as much as you owe on the mortgage. Also, you may find it difficult to refinance your loan to get a lower monthly payment or rate. Even if home prices stay the same, if your loan lets you make minimum payments (see payment-option adjustable rate mortgages), you may owe your lender more on your mortgage than you could get from selling your home.

Prepayment penalties and conversion

If you get an adjustable rate mortgage, 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 adjustable rate mortgage, ask for information about any extra fees you would have to pay if you pay off the loan early by refinancing or selling your home, and whether you would be able to convert your adjustable rate mortgage to a fixed-rate mortgage.

Prepayment penalties

Some adjustable rate mortgages, including interest-only and payment-option adjustable rate mortgages, may require you to pay special fees or penalties if you refinance or pay off the adjustable rate mortgage early (usually within the first 3 to 5 years of the loan). Some loans have expensive prepayment penalties, meaning that you will pay an extra fee or penalty if you pay off the loan during the penalty period for any reason (because you refinance or sell your home, for example). Other loans have soft prepayment penalties, meaning that you will pay an extra fee or penalty only if you refinance the loan, but you will not pay a penalty if you 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 adjustable rate mortgage with an initial rate of 6%. At the end of year 2 you decide to refinance and pay off your original loan. At the time of refinancing, your balance is $194,936. If your loan has a prepayment penalty of 6 months’ interest on the remaining balance, you would owe about $5,850.

Sometimes there is a trade-off between having a prepayment 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 adjustable rate mortgage--such as a 2/28 or 3/27 adjustable rate mortgage--be sure to compare the prepayment penalty period with the adjustable rate mortgage’s first adjustment period. For example, if you have a 2/28 adjustable rate mortgage that has a rate and payment adjustment after the second year, but the prepayment penalty is in effect for the first 5 years of the loan, it may be costly to refinance when the first adjustment is made.

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.

Conversion fees

Your agreement with the lender may include 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 using a formula given in your loan documents.

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 fee at the time of conversion.

Graduated-Payment or Stepped-Rate Loan

Some fixed-rate loans start with one rate for one or two years and then change to another rate for the remaining term of the loan. While these are not adjustable rate mortgages, 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

Disclosures from lenders

You should receive information in writing about each adjustable rate mortgage 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 adjustable rate mortgage features such as negative amortization. After you have applied for a loan, you will get 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 adjustable rate mortgages (for example, compare APRs on a 5/1 and a 3/1 adjustable rate mortgage) 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 adjustable rate mortgage can change, APRs on adjustable rate mortgages cannot be compared directly to APRs for fixed-rate mortgages.

You may want to talk with financial advisers, housing counselors, 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 online to find a center near you.

Newspapers and the Internet

When buying a home or refinancing your existing mortgage, remember to shop around. Compare costs and terms, and negotiate for the best deal. Your local newspaper and the Internet are good places to start shopping for a loan. You can usually find information on interest rates and points for several lenders. Since rates and points can change daily, you’ll want to check information sources often when shopping for a home loan.

Design a Mortgage Shopping Worksheet. 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 business by letting them know that you are shopping for the best deal.

Advertisements

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 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 could increase substantially later. So, get all the facts.

Any ad for an adjustable rate mortgage that shows an initial interest rate should also show how long the rate is in effect and the APR on the loan. If the APR is much higher than the initial rate, your payments may increase a lot after the introductory period, even if interest rates stay the same.

Choosing a mortgage may be the most important financial decision 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 adjustable rate mortgage features when you talk to lenders, mortgage brokers, real estate agents, sellers, and your attorney, and keep asking until you get clear and complete answers.

The information on this site is also available in the brochure "Consumer Handbook on Adjustable-Rate Mortgages." Single or multiple copies of the brochure are available without charge. Order the brochure online.

For more helpful mortgage tips on mortgage rate lock-ins, mortgage refinancing, home loans, reverse mortgages or a home equity line of credit, contact FreeLoanComparison.com today!

Last update: November 14, 2008