The initial interest rate on adjustable-rate mortgages (ARMs) is currently running about 1 percent lower than the rate on a 30-year fixed-rate mortgages (FRMs). However, borrowers who take advantage of the lower ARM rate expose themselves to the risk of future rate increases. A major consideration is how large that risk is.
The risk can be avoided completely by paying off the loan before the first rate adjustment. If the borrower expects to be out of the house in five years, for example, she selects an ARM that holds the initial rate for five years, or (to be safe) for seven years.
But since few homeowners can ever be completely certain about how long they will be in their house, rational ARM borrowers will consider how large a future rate increase might be in the event that they are still there when the rate adjusts.
While future interest rates are not predictable by borrowers, or anybody else, ARM contracts set caps on future rates. A lifetime cap is the maximum rate over the life of the contract. An adjustment cap is the maximum rate change at any one rate adjustment. The adjustment cap at the first adjustment may be larger than the cap on subsequent adjustments.
For example, a 5/1 ARM is one on which the initial rate holds for five years, after which the rate is adjusted every year. The lifetime cap on this ARM might be 5 percent above the initial rate; the first adjustment cap might be 5 percent; and subsequent adjustment caps might be 2 percent. A 3/1 ARM might be the same except that the first adjustment cap would be 2 percent.
Hence, while ARM borrowers cannot know in advance what their future rate will be, they can know the worst possible case. They can know, but whether they do know is not clear.
Loan officers and mortgage brokers often do a slipshod job of explaining future risks, preferring to focus on the advantage of the lower initial rate. Disclosures mandated by the federal government have not helped.
The Truth in Lending statement, administered by the Federal Reserve, has never included any information bearing on ARM risks. Until this year, the same was true of the Good Faith Estimate (GFE) and HUD-1 statements administered by HUD.
But this year, HUD issued new statements, many years in development, that confront the issue. I was recently provoked to take a hard look at how well they have done it by a letter from David Ginsburg, who performs mortgage audits. Ginsburg claimed that HUD had goofed.
On the new GFE, which borrowers receive within three days of submitting a loan application, lenders are required to answer the question: "Can your interest rate rise?" The answer is either "No" or "Yes, it can rise to a maximum of (X) percent. The first change will be in (X)."
This isn’t a terrible disclosure, as it does tell the borrower what the maximum rate is, but it is confusing about when the maximum could be reached. The second sentence indicates how long the initial rate period lasts, but this may or may not be when the maximum rate can kick in.
On the 3/1 ARM described above, assuming it has an initial rate of 3 percent, the lender would answer, "Yes, it can rise to a maximum of 8 percent. The first change will be in 36 months." But because all adjustment caps are 2 percent, the rate won’t get to 8 percent until the third adjustment in month 61.
An unambiguous disclosure would read: "Yes, the rate can increase in month 37 to 5 percent, and to a maximum of 8 percent in month 61."
The HUD-1, which borrowers receive at closing, has an apparent serious mistake brought to my attention by Ginsburg. In response to the same question of whether the interest rate can rise, it includes the statement, "Every change date, your interest rate can increase or decrease by (X) percent."
In cases where the initial adjustment cap differs from subsequent adjustment caps, as with the 5/1 ARM described earlier, the lender does not know which of the caps to enter. Further, the rate cannot increase on an adjustment date if it is already at the maximum, and it cannot decrease if it is already at the minimum.
Bottom line: HUD’s treatment of ARM risk in the GFE is deficient, and in the HUD-1 it is wrong. How long will it take HUD to fix them? Will I be alive to see it? Stay posted.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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