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THE MORTGAGE ENCYCLOPEDIA

THE AUTHORITATIVE GUIDE TO MORTGAGE PROGRAMS, PRACTICES, PRICES, AND PITFALLS

By JACK GUTTENTAG

The McGraw-Hill Companies, Inc.

Copyright © 2010 Jack Guttentag
All rights reserved.
ISBN: 978-0-07-173958-0

Excerpt

CHAPTER 1

A-Credit A borrower with the best credit rating, deserving of thelowest prices that lenders offer.

Also referred to as a “prime” borrower. Most lenders require a FICO score above720. There is seldom any payoff for being above the A-credit threshold, but youpay a penalty for being below it. See Credit Score/Use of FICOScores by Lenders.

A-Minus A general mortgage risk categorization that falls below Abecause the borrower’s credit rating, debt-to-income ratio, and other factors donot, in combination, meet A standards.

Acceleration Clause A contractual provision that gives the lenderthe right to demand repayment of the entire loan balance in the event that theborrower 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 notconcern themselves with it except where the lender has discretion to exercise itwithout conditions. This would be referred to as a “demand feature,” and itwould be flagged on the Truth in Lending Disclosure Statement. If that statementshows “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 theamount owed.

For example, if the monthly interest due on a loan is $600 and the borrower paysonly $500, $100 is added to the amount owed by the borrower. The $100 is theaccrued interest. On a mortgage, accrued interest is usually referred to asNegative Amortization.

Adjustable-Rate Mortgage (ARM) A mortgage on which the interest rate canbe changed by the lender.

While ARM contracts in many countries abroad allow rate changes at the lender’sdiscretion (Discretionary ARMs), in the United States the rate changeson ARMs are mechanical. They are based on changes in an interest rate index overwhich the lender has no control. Henceforth, all references are to suchIndexed ARMs.

Reasons for Selecting an ARM: Borrowers may select an ARM inpreference to a fixed-rate mortgage (FRM) for three reasons, which are notmutually 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 beout 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 andare prepared to take the risk that rising interest rates will cause them to paymore.

I will return to these reasons later.

How the Interest Rate on an ARM Is Determined: There are twophases in the life of an ARM. During the first phase, the interest rate isfixed, just as it is on an FRM. The difference is that on an FRM the rate isfixed for the term of the loan, whereas on an ARM it is fixed for a shorterperiod. The period ranges from a month to 10 years.

At the end of the initial rate period, the ARM rate is adjusted. The adjustmentrule is that the new rate will equal the most recent value of a specifiedinterest rate index plus a margin. For example, if the index is 5% when theinitial 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 exceedany 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 anyinterest rate change.

The second condition is that the new rate cannot exceed the contractual maximumrate. Maximum rates are usually five or six percentage points above the initialrate.

During the second phase of an ARM’s life, the interest rate is adjustedperiodically. This period may be but usually is not the same as the initial rateperiod. For example, an ARM with an initial rate period of 5 years might adjustannually or monthly after the 5-year period ends.

The Quoted Interest Rate: The rate that is quoted on an ARM, bythe media and by loan providers, is the initial rate—regardless of howlong that rate lasts. When the initial rate period is short, the quoted rate isa poor indication of interest cost to the borrower. The only significance of theinitial rate on a monthly ARM, for example, is that this rate may be used tocalculate the initial payment. See How the Monthly Payment on an ARM IsDetermined.

The Fully Indexed Rate: The index plus margin is called the “fullyindexed rate,” or FIR. The FIR based on the most recent value of the index atthe time the loan is taken out indicates where the ARM rate may go when theinitial rate period ends. If the index rate does not change, the FIR will becomethe ARM rate.

For example, assume the initial rate is 4% for one year, the fully indexed rateis 7%, and the rate adjusts every year subject to a 1% rate increase cap. If theindex value remains the same, the 7% FIR will be reached at the end of the thirdyear.

The FIR is thus an important piece of information, the more so the shorter theinitial rate period. Nevertheless, it is not a mandated disclosure, and loanofficers 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, asexplained below.

ARM Rate Indexes: Every ARM is tied to an interest rate index.An index has three relevant features:

• Availability

• Level

• Volatility

All the common ARM indexes are readily available from a published source, withthe exception of one called the Cost of Savings Index, orCOSI, 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% indexwith a 2% margin provides the same FIR as a 2% index with a 3% margin. Assumingvolatility is the same, there is nothing to choose between them.

An index that is relatively stable is better for the borrower than one that isvolatile. The stable index will increase less in a rising rate environment.While it will also decline less in a declining-rate environment, borrowers cantake advantage of declining rates by refinancing.

The most stable of the more widely used rate indexes is the 11th District Costof Funds Index, referred to as COFI (pronounced like “coffee”). Most of theothers are significantly more volatile. These include the Treasury series ofconstant (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 Treasuryconstant maturity series. MTA is a little more volatile than COFI but lessvolatile than the other series.

An ARM should never be selected based on the index alone. That would be likebuying 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 onewith the more attractive index.

The most complete source of current and historical values of major ARM indexescan be found on the Web site www.mortgage-x.com.

How the Monthly Payment on an ARM Is Determined: ARMs fall into twomajor groups that differ in the way in which the monthly payment of principaland interest is determined: fully amortizing ARMs and negative amortizationARMs.

Fully amortizing ARMs adjust the monthly payment to be fully amortizingwhenever the interest rate changes. The new payment will pay off the loan overthe 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 5years, 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 loanif the rate stayed at 5%. In month 61, the rate might increase to, say, 7%. Anew payment of $649.03 is then calculated, at 7% and 25 years, which would payoff 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 remainingperiod if that rate continued.

Negative amortization ARMs allow payments that don’t fully cover theinterest. They have one or more of the following features:

• Payment Rate Below the Interest Rate: The payment rate, which is theinterest rate used to calculate the payment, may be below the actual interestrate. If the payment rate is so low that the initial payment does not cover theinterest, the result will be negative amortization.

• More Frequent Rate Adjustments Than Payment Adjustments: If, e.g., therate adjusts every month but the payment adjusts every year, a large rateincrease within the year will lead to negative amortization.

• Payment Adjustment Caps: If a rate change is large and a paymentadjustment cap limits the size of a change in payment, the result will benegative amortization.

Virtually all ARMs are designed to fully amortize over their term. This meansthat negative amortization can only be temporary and that at some point orpoints in the ARM’s life history the monthly payment must become fullyamortizing.

Two contract provisions are used to assure that negative amortization ARMs payoff at term.

• A recast clause requires that periodically, usually every 5 years, the paymentmust be adjusted to the fully amortizing level.

• A negative amortization cap is a maximum ratio of loan balance to originalloan amount, for example, 110%. If that maximum is reached, the payment isimmediately adjusted to the fully amortizing level, overriding any paymentadjustment cap. In a worst-case scenario, the required payment increase may bevery large.

Identifying ARMs: There are no industry standards foridentifying ARMs, and practices vary across lenders. Some identify their ARMs bythe index used, e.g., “COFI ARM” or “6-month LIBOR ARM.” Some identify theirARMs by the rate adjustment periods, e.g., “5/1” or “3/3.”

None of these shorthand descriptions are of much use to borrowers because thereare so many differences within each. Indeed, even if the features of each werestandardized, to compare one type of ARM with another, one needs to know exactlywhat those features are.

Selecting an ARM to Qualify: It is easier to qualify with an ARMthan with an FRM. In deciding whether an applicant has enough income to meet themonthly payment obligation, lenders usually use the initial interest rate on anARM to calculate the payment, even though the rate may rise at the end of theinitial rate period.

That’s why, when market interest rates increase, ARMs become more common andFRMs less common. Some borrowers who could have qualified with an FRM at thelower rates would now require an ARM to qualify.

However, many borrowers who appear to require an ARM to qualify in fact couldqualify with an FRM. It just takes a little more work. SeeQualification/Meeting Income Requirements/Is an ARM Needed toQualify?

After the financial crisis erupted in 2007, it became common to qualifyborrowers using the FIR rather than the initial rate. If this practicecontinues, it will reduce cyclical sensitivity in the market share of ARMsrelative to FRMs.

Taking Advantage of Low Initial Rates: Borrowers with short timehorizons can take advantage of the relatively low initial interest rates onARMs. 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 andon what the borrower’s attitude is toward risk. For example, a borrower whoexpects 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 justifiestaking the risk of having to pay a higher rate in year 6.

Borrowers who take this risk, whether deliberately as in the example above orinadvertently because they aren’t sure how long they will hold the loan, shouldconsider what can happen at the end of the initial rate period. Suppose theborrower 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% onthe 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 onewith another (or with an FRM) can be very confusing. In this situation,borrowers with short time horizons seeking to take advantage of low initialrates on ARMs are no different from borrowers with longer horizons who seek topay less on the ARM over the life of the loan and are prepared to take the riskthat they will pay more. Both should analyze the potential benefits and riskswith calculators, as explained below.

Gambling on Future Interest Rates: Taking an ARM (when an FRM isan option) is a gamble, and the question is whether it is a good gamble in anyparticular case. A good gamble is one where the borrower can reasonably expectthat the Interest Cost (IC) or Total Horizon Cost (THC) will belower 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 tospecify the time period and the interest rate scenario. The calculators coverFRMs and ARMs with and without negative amortization

Information Needed: All the calculators require the followinginformation about each ARM:

Basic Loan Information

• New loan amount or existing loan balance

• Points

• 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:

Payment Information

• 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 toan “expected” result and is an excellent benchmark. The worst case is exactlythat—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 lessextreme, such as the rising trend scenario used below.

An Illustration: On September 4, 2009, I compared the 5/1 no-negativeamortization ARM and 30-year FRM shown below.

I used my calculator 9ai to calculate the total horizon costs on these mortgagesover varying periods, using three rate scenarios for the ARM. The upward trendassumes an increase of 1% during each of the first 3 years. I assumed theborrower 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 outof the house within 5 years, and is very confident that he or she will be outwithin 7 years. In the worst case, the borrower who stays 7 years fares a littleworse with the ARM than with the FRM, but not much; and with anything less thanthe worst case, the ARM does better. Any borrower who expects to stay more than7 years, however, should avoid the ARM.

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(Continues…)Excerpted from THE MORTGAGE ENCYCLOPEDIA by JACK GUTTENTAG. Copyright © 2010 by Jack Guttentag. Excerpted by permission of The McGraw-Hill Companies, Inc..
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