MLO Mentor: The Adjustable Rate Mortgage, Part II

MLO Mentor is an ongoing series covering best practice compliance for mortgage loan originators (MLOs). This article describes the purpose, popularity and elements of the adjustable rate mortgage (ARM). Review part 1 of MLO Mentor: The Adjustable Rate Mortgage.

The purpose and popularity of ARMs

A adjustable rate mortgage calls for periodic adjustments to both the interest rate and the dollar amount of scheduled payments. This is in contrast to a Fixed-rate mortgage (FRM)which has a fixed interest rate and fixed scheduled payments.

In addition to the market factors that have created demand for all types of mortgages, ARMs tend to be very popular when home prices are high or FRM rates are high. In the past, ARMs allowed borrowers to convert the lower interest rate on an ARM, or even the initial teaser interest rate, into a higher one purchase price.

In addition to the greater purchasing power they provide to a borrower initially, ARMs can attract borrowers planning to:

  • moving within the specified term of the loan;
  • refinancing the loan at a lower interest rate after they improve their creditworthiness; and or
  • Use the money saved by lower ARM rates in higher-yielding investments.

Unfortunately, these plans don’t always work out. During the millennium boom, many loan originators fell into the trap of advising their borrowers to obtain a very short-term ARM with the expectation of refinancing into a fixed-rate loan before the fixed-rate period ended. But when it came time to refinance, the home needed to secure ownership lost in valueor the borrower had lost his job.

In addition, the conditions on some of the more creative ARMs also contained time bombs that exploded in the borrower’s face when the time came to refinance.

All ARMs contain these four elements:

  • an introductory interest rate;
  • an index;
  • a margin; and
  • an adjustment interval.

The introductory rate

That introductory rate is the initial rate on the ARM. The introductory rate is also sometimes referred to as a teaser rate. This interest rate remains fixed for a set period of time, known as introductory time. The introductory phase can last from one month to ten years, depending on the ARM type.

Lenders can set the introductory rate at a discount to the index or whatever they choose, depending on whether they want to attract borrowers to ARM loans. In most cases, however, the introductory interest rate is lower than the interest rate that can be expected during the remaining term of the loan.

In the past (and certainly during the Millennium Boom), many lenders guaranteed borrowers’ loan applications based on this introductory rate. When the introductory rate was adjusted, borrowers were often unprepared for the increase in payments, a phenomenon known as payment shock.

However, the repayment rules (which came into effect in 2014) require lenders to repay borrowers on the basis of a fully indexed interest rateor the highest rate possible for the ARM during the first five years of its life.

Related article:

Customer Questions & Answers: What is the difference between an Adjustable Rate Mortgage (ARM) and a Fixed Rate Mortgage (FRM)?

The index

That index is the first of two components that determine the adjusted interest rate after the introductory period. An ARM is said to be “bound” to an index. The index is basically an interest rate that the loan adjusts to. As the index rises and falls, the interest rate on the ARM also rises.

ARM rate adjustments can be tied to any of a variety of indices. Each index is rebalanced based on various criteria set by the “owner” of the index. Common indices for ARMs are:

  • 11th district Cost of Capital Index (COFI);
  • 12-month Treasury average; and
  • Secured Overnight Funding Rate (SOFR).

That COFI is created monthly and is based on the financing costs actually incurred by the lender in the previous month. Because the COFI is set monthly, it is appropriate for ARMs as it is a short-term benchmark.

That 12-month Treasury average is published by the Federal Reserve Board as a weekly average. It is based on the average yield of government bonds with a remaining term of 12 months. This yield is based on the amount paid by successful bidders on Treasury Securities in the over-the-counter stock market.

Conspicuously missing from the list of common ARM indices is the London Interbank Offered Rate (LIBOR). LIBOR was the index of choice until 2021 – but is now being discontinued. The last one-week and two-month LIBOR adjustments were published on December 31, 2021. The Intercontinental Exchange will continue to publish 1-month, 3-month, 6-month and 12-month LIBOR adjustments through mid-2023. This extension gives existing contracts another opportunity to terminate or restructure them.

Related article:

LIBOR phase-out begins December 31, 2021. Are you ready?

With the decline of LIBOR, the backup rate is the choice Secured overnight financing rate, administered by the Federal Reserve Bank of New York. Unlike LIBOR, SOFR is less prone to manipulation and fraud. This set is based on closed Transactions, particularly in relation to overnight money backed by government bonds.

For housing, homebuyers who choose ARMs have already started seeing SOFR in their notes. As of 2020, Fannie Mae and Freddie Mac’s regulator, the Federal Agency for Housing Financing (FHFA)has banned the purchase of LIBOR-rated ARMs with maturities after December 31, 2021.

The FHFA has also worked to help Fannie Mae and Freddie Mac transition to SOFR. With greater reliability in reported rates will come greater protection for homeowners with ARMs and consumers with other types of credit.

Regardless of the index, its purpose is the same: to be a proxy for changes in the cost of borrowing.

Regulation D requires the index to be earlier:

  • readily available and verifiable by the borrower and beyond the lender’s control [12 CFR §1004.4(a)(2)(i); or
  • based on a formula or schedule identifying the amount the interest rate or finance charge may increase, and the circumstances under which a change may be made to the interest rate. [12 CFR §1004.4(a)(2)(ii)]

Basically, the lender must not arbitrarily and opaquely change a consumer’s interest rate on an ARM. Changes are to be made in a transparent Fashion.

The distance

That edge is the second component that determines the adjusted interest rate after the introductory period. Margin is basically the points that the lender adds to the index to make its profits. The margin varies by lender but usually remains fixed for the life of the loan.

The interest rate of the ARM is determined after the introductory period by adding the index to the margin (at specified intervals and subject to any caps), called a fully indexed interest rate.

For example, if an ARM has an index of 4% and the margin is 2%, the fully indexed rate is 6%. If the index then falls to 2%, the fully indexed rate would be 4%.

The adjustment interval

That adjustment interval is the time between changes in the ARM interest rate. ARMs can be scheduled to adjust every month, every year, every three years, etc. At the end of each adjustment interval, the interest rate on the loan is adjusted to the current index plus the margin. Thus, the monthly mortgage payment changes each time the ARM adjusts.

An ARM with payments that adjust each year is a 1-year ARM. An ARM with payments that are adjusted every three years is a 3-year ARM.

Armed With these ARM basics, real estate professionals can better educate their clients about the pitfalls of temptingly low teaser prices. With mortgage rates climbing at an alpoorIn this clip, homebuyers may swear off FRMs altogether.

Because of the Federal Reserve’s reaction to inflation, FRMs are downright ugly compared to ARMs in 2022. Buyers beware – if the economy slides into an undeclared recession, the sweet introductory rate on today’s ARMs could turn sour tomorrow.

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