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THE MORTGAGE ENCYCLOPEDIATHE AUTHORITATIVE GUIDE TO MORTGAGE PROGRAMS, PRACTICES, PRICES, AND PITFALLS
By JACK GUTTENTAG
The McGraw-Hill Companies, Inc.Copyright © 2010 Jack Guttentag
All right reserved.
Chapter OneA-Credit A borrower with the best credit rating, deserving of the lowest prices that lenders offer.
Also referred to as a "prime" borrower. Most lenders require a FICO score above 720. There is seldom any payoff for being above the A-credit threshold, but you pay a penalty for being below it. See Credit Score/Use of FICO Scores by Lenders.
A-Minus A general mortgage risk categorization that falls below A because the borrower's credit rating, debt-to-income ratio, and other factors do not, in combination, meet A standards.
Acceleration Clause A contractual provision that gives the lender the right to demand repayment of the entire loan balance in the event that the borrower violates one or more clauses in the note.
Such clauses may include sale of the property, failure to make timely payments, or provision of false information.
I have never seen a note that did not have such a clause. Borrowers need not concern themselves with it except where the lender has discretion to exercise it without conditions. This would be referred to as a "demand feature," and it would be flagged on the Truth in Lending Disclosure Statement. If that statement shows "This loan has a Demand Feature ...," the note should be read with care. See Demand Clause.
Accrued Interest Interest that is earned but not paid, adding to the amount owed.
For example, if the monthly interest due on a loan is $600 and the borrower pays only $500, $100 is added to the amount owed by the borrower. The $100 is the accrued interest. On a mortgage, accrued interest is usually referred to as Negative Amortization.
Adjustable-Rate Mortgage (ARM) A mortgage on which the interest rate can be changed by the lender.
While ARM contracts in many countries abroad allow rate changes at the lender's discretion (Discretionary ARMs), in the United States the rate changes on ARMs are mechanical. They are based on changes in an interest rate index over which the lender has no control. Henceforth, all references are to such Indexed ARMs.
Reasons for Selecting an ARM: Borrowers may select an ARM in preference to a fixed-rate mortgage (FRM) for three reasons, which are not mutually exclusive:
They need the low initial payment on an ARM to qualify for the loan they want.
They want the low initial rates and payments on ARMs because they expect to be out of their house before the initial rate period ends.
They expect that they will pay less on the ARM over the life of the loan and are prepared to take the risk that rising interest rates will cause them to pay more.
I will return to these reasons later.
How the Interest Rate on an ARM Is Determined: There are two phases in the life of an ARM. During the first phase, the interest rate is fixed, just as it is on an FRM. The difference is that on an FRM the rate is fixed for the term of the loan, whereas on an ARM it is fixed for a shorter period. The period ranges from a month to 10 years.
At the end of the initial rate period, the ARM rate is adjusted. The adjustment rule is that the new rate will equal the most recent value of a specified interest rate index plus a margin. For example, if the index is 5% when the initial rate period ends, and the margin is 2.75%, the new rate will be 7.75%. The rule, however, is subject to two conditions.
The first condition is that the increase from the previous rate cannot exceed any rate adjustment cap specified in the ARM contract. An adjustment cap, usually 1 or 2% but ranging in some cases up to 5%, limits the size of any interest rate change.
The second condition is that the new rate cannot exceed the contractual maximum rate. Maximum rates are usually five or six percentage points above the initial rate.
During the second phase of an ARM's life, the interest rate is adjusted periodically. This period may be but usually is not the same as the initial rate period. For example, an ARM with an initial rate period of 5 years might adjust annually or monthly after the 5-year period ends.
The Quoted Interest Rate: The rate that is quoted on an ARM, by the media and by loan providers, is the initial rate—regardless of how long that rate lasts. When the initial rate period is short, the quoted rate is a poor indication of interest cost to the borrower. The only significance of the initial rate on a monthly ARM, for example, is that this rate may be used to calculate the initial payment. See How the Monthly Payment on an ARM Is Determined.
The Fully Indexed Rate: The index plus margin is called the "fully indexed rate," or FIR. The FIR based on the most recent value of the index at the time the loan is taken out indicates where the ARM rate may go when the initial rate period ends. If the index rate does not change, the FIR will become the ARM rate.
For example, assume the initial rate is 4% for one year, the fully indexed rate is 7%, and the rate adjusts every year subject to a 1% rate increase cap. If the index value remains the same, the 7% FIR will be reached at the end of the third year.
The FIR is thus an important piece of information, the more so the shorter the initial rate period. Nevertheless, it is not a mandated disclosure, and loan officers may not have it. They will know the margin and the specific index, however, and the most recent value of the index can be found on the Internet, as explained below.
ARM Rate Indexes: Every ARM is tied to an interest rate index. An index has three relevant features:
All the common ARM indexes are readily available from a published source, with the exception of one called the Cost of Savings Index, or COSI, which is no longer offered on new loans.
In principle, a lower index is better for a borrower than a higher one. However, lenders take account of different index levels in setting the margin. A 3% index with a 2% margin provides the same FIR as a 2% index with a 3% margin. Assuming volatility is the same, there is nothing to choose between them.
An index that is relatively stable is better for the borrower than one that is volatile. The stable index will increase less in a rising rate environment. While it will also decline less in a declining-rate environment, borrowers can take advantage of declining rates by refinancing.
The most stable of the more widely used rate indexes is the 11th District Cost of Funds Index, referred to as COFI (pronounced like "coffee"). Most of the others are significantly more volatile. These include the Treasury series of constant (1-, 2-, or 3-year) maturity, 1-month, 6-month, and 12-month LIBOR, 6- month CDs, and the prime rate.
Another series known as MTA is a 12-month moving average of the 1-year Treasury constant maturity series. MTA is a little more volatile than COFI but less volatile than the other series.
An ARM should never be selected based on the index alone. That would be like buying a car based on the tires. But if an overall evaluation (see below) indicates that two ARMs are very close, preference could be given to the one with the more attractive index.
The most complete source of current and historical values of major ARM indexes can be found on the Web site www.mortgage-x.com.
How the Monthly Payment on an ARM Is Determined: ARMs fall into two major groups that differ in the way in which the monthly payment of principal and interest is determined: fully amortizing ARMs and negative amortization ARMs.
Fully amortizing ARMs adjust the monthly payment to be fully amortizing whenever the interest rate changes. The new payment will pay off the loan over the period remaining to term if the interest rate stays the same.
For example, a $100,000 30-year ARM has an initial rate of 5%, which holds for 5 years, after which the rate is adjusted every year. (This is referred to as a "5/1 ARM.") The payment of $536.83 for the first 5 years would pay off the loan if the rate stayed at 5%. In month 61, the rate might increase to, say, 7%. A new payment of $649.03 is then calculated, at 7% and 25 years, which would pay off the loan if the rate stayed at 7%. As the rate changes each year thereafter, a new payment is calculated that would pay off the loan over the remaining period if that rate continued.
Negative amortization ARMs allow payments that don't fully cover the interest. They have one or more of the following features:
Payment Rate Below the Interest Rate: The payment rate, which is the interest rate used to calculate the payment, may be below the actual interest rate. If the payment rate is so low that the initial payment does not cover the interest, the result will be negative amortization.
More Frequent Rate Adjustments Than Payment Adjustments: If, e.g., the rate adjusts every month but the payment adjusts every year, a large rate increase within the year will lead to negative amortization.
Payment Adjustment Caps: If a rate change is large and a payment adjustment cap limits the size of a change in payment, the result will be negative amortization.
Virtually all ARMs are designed to fully amortize over their term. This means that negative amortization can only be temporary and that at some point or points in the ARM's life history the monthly payment must become fully amortizing.
Two contract provisions are used to assure that negative amortization ARMs pay off at term.
A recast clause requires that periodically, usually every 5 years, the payment must be adjusted to the fully amortizing level.
A negative amortization cap is a maximum ratio of loan balance to original loan amount, for example, 110%. If that maximum is reached, the payment is immediately adjusted to the fully amortizing level, overriding any payment adjustment cap. In a worst-case scenario, the required payment increase may be very large.
Identifying ARMs: There are no industry standards for identifying ARMs, and practices vary across lenders. Some identify their ARMs by the index used, e.g., "COFI ARM" or "6-month LIBOR ARM." Some identify their ARMs by the rate adjustment periods, e.g., "5/1" or "3/3."
None of these shorthand descriptions are of much use to borrowers because there are so many differences within each. Indeed, even if the features of each were standardized, to compare one type of ARM with another, one needs to know exactly what those features are.
Selecting an ARM to Qualify: It is easier to qualify with an ARM than with an FRM. In deciding whether an applicant has enough income to meet the monthly payment obligation, lenders usually use the initial interest rate on an ARM to calculate the payment, even though the rate may rise at the end of the initial rate period.
That's why, when market interest rates increase, ARMs become more common and FRMs less common. Some borrowers who could have qualified with an FRM at the lower rates would now require an ARM to qualify.
However, many borrowers who appear to require an ARM to qualify in fact could qualify with an FRM. It just takes a little more work. See Qualification/Meeting Income Requirements/Is an ARM Needed to Qualify?
After the financial crisis erupted in 2007, it became common to qualify borrowers using the FIR rather than the initial rate. If this practice continues, it will reduce cyclical sensitivity in the market share of ARMs relative to FRMs.
Taking Advantage of Low Initial Rates: Borrowers with short time horizons can take advantage of the relatively low initial interest rates on ARMs. For example, at a time when a borrower is quoted 6.5% on a 30-year FRM, the quoted initial rates on 3/1, 5/1, 7/1, and 10/1 ARMs might be 6%, 6.125%, 6.25%, and 6.375%, respectively.
The correct choice depends on how long the borrower expects to have the loan and on what the borrower's attitude is toward risk. For example, a borrower who expects to hold the mortgage for 6 years might play it safe by selecting a 7/1. Or he might take the 5/1 on the grounds that the savings over 5 years justifies taking the risk of having to pay a higher rate in year 6.
Borrowers who take this risk, whether deliberately as in the example above or inadvertently because they aren't sure how long they will hold the loan, should consider what can happen at the end of the initial rate period. Suppose the borrower deciding between the 5/1 and 7/1, for example, finds that the indexes, margins, and maximum rates are the same, but the rate adjustment caps are 2% on the 5/1 and 5% on the 7/1. This could tilt the decision toward the 5/1.
If the ARMs being compared differ in a number of ways, however, comparing one with another (or with an FRM) can be very confusing. In this situation, borrowers with short time horizons seeking to take advantage of low initial rates on ARMs are no different from borrowers with longer horizons who seek to pay less on the ARM over the life of the loan and are prepared to take the risk that they will pay more. Both should analyze the potential benefits and risks with calculators, as explained below.
Gambling on Future Interest Rates: Taking an ARM (when an FRM is an option) is a gamble, and the question is whether it is a good gamble in any particular case. A good gamble is one where the borrower can reasonably expect that the Interest Cost (IC) or Total Horizon Cost (THC) will be lower on the ARM than on a comparable FRM over the period the mortgage is held, and where the borrower won't face extreme hardship if interest rates explode.
On my Web site, there are six calculators in the Comparing Two Mortgages (9) series that compare IC or THC, and there are six in the Mortgage Payment (7) series that show mortgage payments month by month. All of them allow the user to specify the time period and the interest rate scenario. The calculators cover FRMs and ARMs with and without negative amortization
Information Needed: All the calculators require the following information about each ARM:
Basic Loan Information
New loan amount or existing loan balance
Other settlement costs
Initial interest rate on new loan or current rate on existing loan
New loan term or remaining term on existing loan, in months
Interest Rate Index
Most recent value of the index
Margin that is added to interest rate index
First Rate Adjustment
Period over which initial rate holds
Maximum interest rate change on first rate adjustment
Subsequent Rate Adjustments
Duration between subsequent rate adjustments
Maximum interest rate change on subsequent rate adjustments
Maximum and Minimum Rates
Maximum interest rate over life of mortgage
Minimum interest rate over life of mortgage
On negative amortization ARMs, the following are also needed:
Initial monthly payment of principal and interest
Payment adjustment period, in months
Payment adjustment cap, in percent
Payment recast period, in years
Negative amortization cap, in percent
Assumptions About Future Interest Rates
The stable index or "no-change" scenario provides the closest approximation to an "expected" result and is an excellent benchmark. The worst case is exactly that—the ARM rate rises as far and as fast as the loan contract permits. The worst case is so improbable that borrowers may want to design something less extreme, such as the rising trend scenario used below.
An Illustration: On September 4, 2009, I compared the 5/1 no-negative amortization ARM and 30-year FRM shown below.
I used my calculator 9ai to calculate the total horizon costs on these mortgages over varying periods, using three rate scenarios for the ARM. The upward trend assumes an increase of 1% during each of the first 3 years. I assumed the borrower had an interest opportunity cost of 2% and was in the 27% tax bracket.
It is clear that the 5/1 ARM is a winner for any borrower who expects to be out of the house within 5 years, and is very confident that he or she will be out within 7 years. In the worst case, the borrower who stays 7 years fares a little worse with the ARM than with the FRM, but not much; and with anything less than the worst case, the ARM does better. Any borrower who expects to stay more than 7 years, however, should avoid the ARM.
Excerpted from THE MORTGAGE ENCYCLOPEDIA by JACK GUTTENTAG Copyright © 2010 by Jack Guttentag. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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