ADJUSTABLE RATE MORTGAGES (ARMs)
Display of ARM (5 / 1)
(5 / 1) on a 30-year loan. • 5 → 5-year fixed rate. • 1 → adjusts each year after the 5-year fixed period (rate adjustment period). • On a 30-year fixed period, there is 5 fixed interest rates for first 5 years. • On a 30-year fixed period, there are 25 adjusted interest rates until the end of the term (25 x 1 = 25)
Calculating Interest Rate Interest Rate (Nominal Rate) (Note Rate)
1. Initial Rate = what's offered by the lender - no formula to figure out. 2. Margin = determined by lender - never changes. 3. Index = set by the market, picked by the lender 4. Fully Indexed Rate = Current Index Value + Margin 5. Interest Rate = Initial Rate to the Fully Indexed Rate (can't go above caps).
ARM Overview
ARM's frees lenders from being locked into a fixed-interest rate for the entire life of the loan. • Interest rates may adjust, according to the terms in the note, to reflect the current cost of money. • Popular alternative financing tool as they may help borrowers qualify more easily for a home loan or for a more expensive home - usually offered at a lower interest rate than a fixed rate loan. • Many lenders like ARM's because they can pass the risk of fluctuation interest rates on to borrowers. • ARM that allows a borrower to convert the loan to a fixed rate has a conversion option. • Four factors involved in determining an ARM's movement: frequency of change, caps, index, and margin.
Interest Only ARM (IO)
Allows payment of interest only for a specified number of years (typically between 3 and 10 years). This allows the borrower to have smaller monthly payments for a period of time. After that, monthly payments increase even if interest rate stay the same, because the borrower must start repaying the principal and interest each month. • Usually Home Equity Line of Credit (HELOC).
Option ARM
Allows the borrower to choose among several payment options each month. o Provides flexibility for borrowers by allowing them to choose the payment that suits their current financial situation. Offer a variety of payment options, such as a minimum payment (can lead to negative amortization), a 15 year or 30-year amortized payment, or an interest only payment.
Hybrid ARM (initial, margin, index, caps changes) (Traditional Mortgage Loan)
Combines the features of a fixed-rate loan with those of an adjustable-rate loan. o Hybrid ARM may be desirable for borrowers who plan to sell their homes or pay off their loans within a few years. o The fixed-rate feature gives the borrower some security with fixed payments in the initial term of the loan. o The adjustable-rate feature is that the initial interest rates on these loans are typically lower than a fixed rate loan. o Initially, a fixed interest rate exists for a period of 3, 5, 7, or 10 years. • Often advertised as 3/1, 5/1 or 10/1 ARMs. o These loans are a mix (hybrid) of a fixed-rate period and an adjustable-rate period. The interest rate is fixed for the first few years of these loans. o For example, for 5 years in a 5/1 ARM. After that, the rate may adjust annually (the 1 in the 5/1 example) until the loan is paid off. o The first number tells how long the fixed interest rate period will be. o The second number tells how often the rate will adjust after the initial period.
Components of ARMs
Components to an Adjustable Rate Mortgage (ARM) include: o Index o Margin o Rate Adjustment Period o Interest Rate Cap / Floor (if any) o Conversion options (if any)
Rate Change Disclosures
Creditors or loan advisors must make these post-closing (after closing) disclosures no less than 60 days, and no more than 120 days, prior to the effective date of a rate change. • The disclosure must include a table that shows the current and new interest rate payments.
Loan Program Disclosure
Depending on the ARM you get, these are required for each variable-rate product in which the consumer states an interest. • The information disclosed includes, but is not limited to: o A statement that the interest rate and payments may change. o The formula used to make rate adjustments o An explanation of how rate changes are calculated o The frequency of rate changes o A notice that the consumer will receive future rate change disclosures, and a description of the timing for these disclosures **You'll receive disclosure every time rate is about to adjust**
Index
Economic measurement used to make periodic interest adjustments for an ARM. o Based on market, use the index to figure out how much interest rate will increase and decrease. o Index says, based on market, cost of the doing an ARM fluctuates o Index is the cost of money o Number on index changes, but index being used does not change. • Lender chooses the index; lender has no control over measurement of the index. • Because of market forces, the index fluctuates during the term of the loan, causing the borrower's actual interest rate to increase or decrease. • A fully indexed rate is the combination of the index and the margin. • The plural of index is indices, not indexes. • The specific index is used to determine the rate adjustments that must be disclosed to a potential borrower on the Loan Estimate. • The index also appears on the promissory note when the loan goes to closing. • The most common indices are: o The Constant Maturity Treasury (CMT) o The 11th District Cost of Fund Index (COFI) o The London Inter Bank Offering Rates (LIBOR) o The Bank Prime Loan Rate (Prime Rate)
Fully Indexed Rate
Index + Margin = Fully Indexed Rate (what the borrower pays on the loan). • What your interest rate would adjust to on the day that it adjusts, with exceptions of the caps preventing it to. • Fully Indexed Rate IS NOT the interest rate, but it can be DEPENDING on the caps. o Current Index Value = 4.25% o Margin = 2% o Fully Indexed Rate = 6.25%
Initial Rate (Introduction Rate) (Start Rate) (Note Rate)
Initial Rate → no formula to figure out, LENDER WILL OFFER rate. • No matter the margin or index, the initial rate is given by the lender. • Remains in effect for a period of time ranging from 1 month to 10 years depending upon the loan product. • THE INITIAL RATE IS NOT THE FULLY INDEXED RATE.
Lender's Prime Rate
Lender's prime rate is determined by the lender itself. • Interest rates are affected by actions taken by the Federal Reserve, but the Feds do not directly influence the interest rates that lenders charge borrowers. • Each lender will set its own prime rates (i.e., the lowest rates it charges for its best customers), as well as rates for loans to other customers based on its costs and desired profit margin.
Types of ARMs
Lenders offer a variety of ARMs, including: Interest only-ARMs, Payment-option ARMs, Convertible ARMs, Hybrid ARMs
Periodic Cap
Limits the amount the interest rate can adjust up or down from one adjustment period to the next. • How much the rate can go up and down after first adjustment period / initial rate.
Margin (Spread)
Margin is the desired profit for the lender. • For the life of the loan, the margin is set and will NEVER change (fixed number). • Margin can vary greatly between different lenders. • Margin represents the lender's operating costs and profit margin. • Margin is also disclosed on the Loan Estimate. • Set and controlled by the lender, no matter how much index changes, margin will never change.
Balloon Program
Mortgage products that have a balloon payment due within 5 or 7 years may be referred to as 5/25 and 7/23 loans, respectively Loan is fixed for 5 or 7 years, after 5 years whatever is left is due, has a conditional refinance feature. • Notations of 5/30, 7/30, 10/30, or 15/30 indicate there is a balloon feature without a conditional refinance provision. Loan is fixed for 5 or 7 years, whatever is left is due, has no conditional refinance feature.
Initial Cap
On the first adjustment period, how high or low rate can possibly go.
Recasting
Option ARM payments are typically adjusted every 5 years. o Lenders do this by amortizing the higher principal balance created by the addition of interest (negative amortization). o This automatic payment adjustment is called recasting. o It amortizes the loan so it can be paid in full by the end of the loan term. o The time in the loan term where periodic payments must be of sufficient amount to fully amortize the loan within the remaining term o Occurs at the end of the period during which payments on an ARM are based on a low introductory rate.
Interest Rate Caps (Adjustment Caps)
Protection for the borrower from payment shock and market changes called caps. • Limitation on the amount that an interest rate may increase or decrease either at the adjustment date or over the lifetime of the loan. • Used with ARM's to limit the number of percentage points an interest rate can be increased during the term of a loan, helping to eliminate large fluctuations in mortgage payments. • Caps regulate how much the interest rate can increase in a given period.
Caps can also appear as 2 numbers: (Periodic / Lifetime) (2/6)
Rate caps are more commonly shown as two numbers - for example: 2/6 o 2/6 - 1st number (2) = maximum amount interest can increase / decrease from one adjustment period to the next. 2/6 - 2nd number (6) = maximum amount the interest can increase during the life of the loan. • Basically, we drop the initial cap from the equation. Read the question carefully about what information you are given.
Consumer Handbook on Adjustable-Rate Mortgages (CHARM Booklet):
Required to be delivered 3 business days after application. • This booklet provides information on: o Rate adjustments o Calculation adjustments o Risk of ARM's
Lifetime Cap
Sets a maximum number of percentage points that the rate can increase over the start rate for the life of the loan functioning as a rate ceiling.
Caps usually appear as 3 numbers: (Initial/Periodic/Lifetime) (5/2/6)
Some ARMs allow for a higher rate change at the first adjustment and then apply a periodic adjustment cap to future adjustments. • These ARMs are usually identified with three numbers - for example: 5/2/6 5% at the first adjustment. The 1st number is the initial interest rate cap for the first adjustment. 2% for subsequent adjustable periods. The 2nd number is the period adjustment cap. 6% total over the life of the loan. The 3rd number is the lifetime interest rate cap.
Rate Floor
Sometimes included in a lending agreement in order to protect the lender, • Lowest interest rate can go to which an ARM may adjust. • For loans sold to Fannie Mae or Freddie Mac, this is usually identical to the margin.
Protecting Consumers from the Risks of Adjustable Rates Mortgages (ARM's)
TILA includes a number of special disclosure requirements for ARM's that are intended to reduce the risks associated with these products. • The disclosure requirements are the: o CHARM Booklet o Loan Program Disclosure o Rate Change Disclosures
Convertible ARM
The ARM may have a conversion option - making it a convertible ARM. o To change from an adjustable fixed-rate mortgage, a refinance of the transaction is generally required o You can move from an ARM to a fixed rate at any time o The lender may charge a one-time fee at the time the loan is converted to a fixed rate. o When the loan converts, it converts to the current prevailing rate.
(Variable Rate Loan)
The interest on the loan varies upward (+) or downwards (-) over the term of the loan depending on money market conditions and the agreed upon index. • The interest rate on the ARM only changes if the chosen index changes. o The only thing that changes on the ARM is whatever index we're using to determine the market value, if the index goes up and down, ARM goes up and down. • The borrower's payments may stay the same for a specified time (for example one year or two years) depending on the borrower's agreement with the lender.
Adjustable Rate Mortgages (ARM)
The rate adjusts while you're in the mortgage. • There's a starting interest rate and depending on the ARM, the rate goes up or down.
Teaser Rate
When the introductory (initial) rate is lower than the fully-indexed rate at the time of closing, it's known as a teaser rate.