The SECURE AND FAIR ENFORCEMENT ACT OF 2008 states: “A nontraditional mortgage product is any product other than a 30-year fixed- rate mortgage”. (Title V, Sec. 1503 (6). That is simple as stated before, but in the “Guidance on Nontraditional Mortgage Product Risks”the definition of NTM states that it includes “interest-only” and “payment options” terms such adjustable-rate mortgages (ARM’s) where a borrower has flexible payment options with the potential for negative amortization.
In many publications the loans are called “exotic” and “toxic”. But the loans have many uses and could be great loans for many individuals. It is important for MLO students to understand there features. As in all loans, it is important to Disclose, Disclose, and Disclose again. But it would be professional to know what to disclose. Hence this section.
For a point of order: There are two government definitions, so for test purposes and discussions we will use the SAFE ACT term. The SAFE ACT was effective in 2008 and the Guidance was effective 2006 so the SAFE ACT is more recent. Also, you will notice many different spellings of Nontraditional but both the SAFE ACT and the Guidance spell it with no hyphen so we will use that writing.
Wellenkamp, Garn, et al.
In 1978 the California State Supreme Court ruled in the Wellenkamp decision that lenders could not enforce any “due on sale clauses” if the buyer had “comparable credit”. Obviously lenders did not appreciate this decision so they influenced Congress to pass the Gam-St. Germain Depository Institutions Act in 1982. This Act stated simply that due on sale clauses could be enforced. For mortgage loan originators those four years from 1978 to 1982 were memory makers. High double digit interest rates were common, and creative financing was used by many buyers and lenders. This included wrap around mortgages. Also, a Financing Disclosure form was required by State regulation.
There was another aspect of the Act. It allowed lenders to market Adjustable Rate Mortgages. An important addition to the alternative methods of borrowing. You might want to consider learning the nuances of these mortgages, just in case.
Details of ARMs
Index – The index is selected at the origination of a loan. The index is the cost of money determined by market forces. As the index fluctuates, so does the interest rate.
Margin – The margin is a fixed amount that when added to the index determines the interest rate.
Fully Indexed Rate or Note Rate – The fully indexed rate is the total of the Index & Margin.
Periodic Interest Rate Cap – The periodic interest rate cap is the maximum that the interest rate can increase from one adjustment period to the next.
Lifetime Interest Rate Cap – The lifetime interest rate cap is the maximum that the interest rate can increase during the term of the loan.
Initial Rate Adjustment Cap – If the loan has an initial rate adjustment cap, it is used only once for the first adjustment.
Hybrid ARM;s – Hybrid ARM’s have a fixed rate for longer than one year before the rate adjusts. Up to this point the examples given are for 1 year ARM’s. Any loan that remains fixed for 2 or more years and then adjusts would be a hybrid ARM. The description of a loan that is fixed for 2 years and then adjusts each following year would be a 2/1 Hybrid ARM.
Discussion Points of ARMs
ARM’s are not for every borrower or trustor. ARM’s might be just right for some borrowers and trustors.
ARM’s are much more difficult to explain than the old 30-year fixed rate, fully amortized loan.
ARM’s are misunderstood by borrowers (trustors), and some inexperienced MLO’s do not explain them well.
ARM’s have been known to cause problems for borrowers (trustors), beneficiaries, MLO Company Owners, Servicers, and MLO’s.
Interest Rates
The interest rate is based on two factors, Index and Margin. The index rate reflects the current market and is normally selected by the lender and then technically approved by the applicant. The new CHARM book says that indices can include the U.S. prime rate and the Constant Maturity Treasury (CMT). Nothing is said about LIBOR anymore. The margin is the extra percentage that the lender adds to the loan, their gross operating income. A future borrower can shop for a preferred index and a lower margin. The Loan Estimate shows the index and the margin being offered to the applicant.
The original interest rate is a combination of the index and the margin, the fully indexed rate. This rate will not remain long. In a 5/1 ARM the 5 indicates the length of time the initial rate lasts and the 1 tells you how often the rate changes after that.
Paying Points
Lenders may offer a lower interest rate if an applicant pays “points”. One point is 1% of the loan amount. Borrowers should check to make certain how long the lower interest rate applies. Also, this is an option and is not mandatory. A before and after comparison should be completed before agreeing to pay any extra fees.
Conversion Option
This feature would allow the borrower to convert the loan to a fixed loan in the future. Information on the option should be received before any documents are signed and should include when it can be done, the fixed rate that will be used in the future, and if there are any conversion fees at the signing or at time of conversion.
Teaser Rates
This feature is fully described by its title. They could be called starter or discounted rates and end very quickly in many cases.
Interest-Only ARMs
You pay only interest for a period of time. This will make the beginning payment much lower. Many borrowers look only to how much is their payment. Then, when the initial period ends, a fully amortizing payment will start and this will be much higher.
Borrowers must be warned that some of these choices could lead to Negative Amortization. All government publications describe this as exotic, toxic, dangerous and many other terms. If fully explained to the proper category of borrowers, this could be a good loan. I am a believer in paying as little as I can now so I can use the money that would go to my monthly payment for another more important object. BUT, Negative Amortization must be understood by borrowers. My mother would call this, “Robbing Peter to pay Paul.”
Many of you have worked with ARM’s for many years and since you have all passed the National Exam, you have studied the Basics of ARM’s.
Therefore, I believe that we can cover the Basics quickly and spend our time on the more important part of ARM’s and that is Disclosure. Most of the problems that arise on these loans are because the borrowers do not understand them. So Disclose, Disclose, and then Disclose again. To Disclose you have to know what to Disclose.
Every ARM applicant must be given a copy of a required booklet due to Federal Law. The name of this important booklet is Consumer Handbook on Adjustable Rate Mortgages (CHARM).
The applicants might have questions, and it would be to your advantage to anticipate their questions and have professional answers. You might say that you have never done an ARM and will never do one. But circumstances change and the market can change so you should be ready for change. Let’s see what borrowers are being told.
CHARM Booklet
There have been some recent corrections to the CHARM Booklet[1] given to applicants. The original booklet published by the Federal Reserve Board was outdated. The new edition has brought the material up-to-date according to new regulations and eliminated about 20 pages.
How to Use the Booklet
When an applicant and their mortgage lender discuss adjustable-rate mortgages (ARMs), the applicant receives a copy of this booklet. When someone applies for an ARM loan, they receive a Loan Estimate. A borrower may receive multiple Loan Estimates from competing lenders when trying to get the best loan.
You may want to have your Loan Estimate handy for any loan you are considering as you work through this booklet. We reference a sample Loan Estimate throughout the booklet to help you apply the information to your situation.
About the CFPB’s Mission
The Consumer Financial Protection Bureau regulates the offering and provision of consumer financial products and services under the federal consumer financial laws
and educates and empowers consumers to make better informed financial decisions.
How can this booklet help you, the applicant?
This booklet can help you decide whether an adjustable-rate mortgage (ARM) is the right choice for you and to help you take control of the home buying process.
Your lender may have already provided you with a copy of Your Home Loan Toolkit. You can also download the Toolkit from the CFPB’s Buying a House Guide at cfpb.gov/buy-a-house/.
An ARM is a mortgage with an interest rate that changes, or “adjusts”, throughout the loan. With an ARM, the interest rate and monthly payment may start out low.
However, both the rate and the payment can increase very quickly. Consider an ARM only if you can afford increases in your monthly payment—even to the maximum amount.
After you finish this booklet:
- You’ll understand how an ARM works and whether it’s the right choice for you.
- You’ll know how to review important documents when you apply for an ARM.
- You’ll understand the risks that come with different types of ARMs.
The Latest Updates to the CHARM Booklet
- It was aligned with the Bureau’s education efforts to be more concise and to improve readability and usability.
- Added a comparison table for comparing adjustable to adjustable and adjustable to fixed rate loans.
- Added a tutorial on how to review an ARM Estimate and a lender’s ARM program disclosure.
- Another table allowing the borrower to review loan offers they have received.
- A description of the risks that come with the different types of ARM’s.
- A significant portion is devoted to telling borrowers to review the Loan Estimate normally received at the same time as this booklet.
Time to Calculate Rates
Consider the following information: A borrower gets a 1 year ARM loan for $500,000.00 for 30 years. Terms are 5/2/6. The current index rate
is 4.5%, the margin is 3% and the discounted start rate is 4%.
- What is the interest rate for the first year?
- What is the rate for the second year assuming a new index of 6.5%?
- What is the rate for the third year assuming an index of 4%?
- What is the rate for the fourth year assuming an index of 7%?
- What is the rate for the fifth year assuming an index of 8%?
Answers:
- The fully indexed rate for the first year would be 7.5%. However, the discounted rate is 4% which is the borrower’s rate.
- The fully indexed rate for the second year would be 9.5%. (6.5% index rate plus 3% margin). However, the prior year’s interest was 4% and the initial rate adjustment cap is listed as 5% so the correct rate for the second year is 9%, the lower of the two rates.
- The fully indexed rate for the third year would be 7% (4% plus 3%). The prior year’s interest was 9% plus a 2% adjustment after the initial adjustment so the interest rate for the borrower would be 7%.
- The fully indexed rate for the fourth year would be 10% (7% plus 3%) and the adjusted rate would be the prior year’s rate of 7% plus the 2% adjustment or 9% so the borrower’s rate would be 9%.
The fully indexed rate for the fifth year would be 11% (8% plus 3%) and the adjusted rate would be the prior year’s rate of 9% plus the two percent adjustment for a total of 11%. BUT the 6 in 5/2/ limits the total as 6% plus the start of 4% or 10% for the final answer
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