How Much Disclosure Is Enough?

It’s hardly a secret that few borrowers fully understand their mortgage options. A 2006 Federal Reserve study found that 20 percent of all ARM borrowers did not know their original loan rate and 35 percent had no idea how much their monthly payment could increase with each adjustment. Amazingly, 41 percent didn’t even know the maximum interest rate for their loans.

In a 2007 study, the Federal Trade Commission came to similar conclusions: 

  • Current mortgage cost disclosures failed to convey key mortgage costs to many consumers.
  • Both prime and subprime borrowers failed to understand key loan terms when viewing the current disclosures, and both benefitted from improved disclosures.
  • Improved disclosures provided the greatest benefit for more complex  loans, where both prime and subprime borrowers had the most difficulty understanding loan terms.

As these surveys show, disclosure requirements for real estate financing have plainly been inadequate. If large numbers of borrowers are not aware of basic loan costs, one can only imagine what they’ve missed in terms of prepayment penalties, lender fees and hidden charges.

In an effort to better-educate consumers in the face of rising foreclosure levels, federal regulators have now proposed a new set of mortgage disclosures. This surely sounds like a good idea, but — as they expression goes — the devil is in the details.

For instance, take a look at the proposed table prepared by federal regulators. It compares the payments for a fixed-rate loan with a model ARM. But does it better inform the public?

The model fixed rate loan shows the monthly cost of borrowing $200,000 over 30 years at 7.5 percent. The monthly payment, says the chart, will be $1,598 every month for the life of the loan, assuming $200 a month for taxes and interest.

The assumption regarding taxes and insurance — an assumption used for both the fixed-rate and adjustable-rate loan products — raises a question: Of the millions of homes in the US, how many have had unchanged tax and insurance costs during the past five years? Rising governmental costs assure increased property taxes while insurance rates in many states have soared in recent years because of hurricanes, floods and other hazards. The property tax and insurance assumptions made within the chart are inherently unrealistic, do not disclose the real-world likelihood of rising taxes and growing insurance costs and therefore understate potential costs.

The Mysterious ARM Table
The chart tracks a model 2/28 ARM with a 7 percent start rate. The maximum rate in year three, says the chart, is 10 percent, 11.5 percent in year four and 13 percent thereafter. In other words, this loan has a 1.5 percent periodic cap, a 3 percent reset cap and a 6 percent lifetime cap.

Where the federal government found such a loan is impossible to say, but a more typical arrangement would be a 2 percent periodic cap, a 3 percent to 5 percent first adjustment cap and a 6 percent lifetime cap. Again, real world costs are understated.

The government example does not tell us if the model ARM allows negative amortization. Do the monthly ARM payments pay off the loan — as is the case with fixed-rate financing — or does the debt increase if the ARM monthly payment does not cover all interest? Given the absence of any statement to the contrary there’s no way to tell.

By The Numbers
According to the chart the monthly cost of the ARM for principal, interest, taxes and insurance amounts to $1,531 in year one — that’s $67 a month less than the $1,598 cost of the fixed-rate loan.

The chart then goes on to year three and we see that the fixed-rate loan monthly cost remains at $1,598 while the adjustable is now at $1,939. That’s an increase of $408 (26.6 percent) over year one and $341 per month ($4,092 per year) more than the fixed-rate loan.

The math here is curious. The chart gives results “if rates don’t change” but the adjustable rate at the start of year three is actually calculated at 10 percent — not 7 percent — so the rate did change!

(At the start of year three the loan balance is $195,789.89. At 10 percent interest over 28 years, the remaining loan term, the cost for principal and interest is $1,738.54. Add $200 for taxes and insurance and you get the $1,939 shown on the chart.)

In year four, the chart shows that the ARM payment increases to $2,152 — up $554 a month ($6,648 more per year) when compared with the fixed-rate loan. But, again, it’s stated that the results are shown “if rates don’t change” and — once more — this is not the case. The monthly payment number is calculated 11.5 percent, not 10 percent interest.

(At the start of year four, the ARM loan has a balance of $194,445.95. At 11.5 percent interest, the monthly payment is $1,952.25. Add $200 for taxes and insurance and you have $2,152.)

In year five the ARM payment is up to $2,370, now a whooping $772 a month ($9,264) more than the fixed rate loan.

In year five the chart gives an ARM payment figure “if rates rise 2 percent.” However, the actual rate which would produce the payment shown in the chart is 13 percent — a 1.5 percent increase over year four.

In the case of year five, the starting loan balance is $193,322.20 and now the monthly payment for principal and interest at 13 percent is $2,169.55. Add $200 for taxes and insurance and you get $2,371.

It appears that what the regulators are trying to do is to show the maximum cost increases for the ARM. That’s an appropriate approach, but why not go further?

For instance, why not show the monthly and yearly cost differential between the fixed-rate and adjustable mortgages? Why not increase taxes and insurance 5 percent a year or such other figure as may be justified by the recent historical record?

Comparing Potential Costs
Looking at the government’s chart, you have to wonder: Why not show the potential cost difference after five years? The fixed-rate borrower in the federal chart will pay a total of $95,880 over five years ($1,598 x 60 = $95,880). As to the adjustable-rate borrower, their projected costs look like this:

  • Years one and two: $36,744 ($1,531 x 24 = $36,744)
  • Year three: $23,268 ($1,939 x 12 = $23,268)
  • Year four: $25,704 ($2,152 x 12 = $25,824)
  • Year five: $28,440 ($2,370 x 12 = $28,440)
  • Total: $114,276

If total loan costs for the first five years are known, then borrower options become clearer: Would you rather pay $95,880 or as much as $114,276 for a loan of the same size? That’s a potential difference of $18,396 in a worst-case scenario for an ARM borrower.

Some borrowers may look at such figures and say they want the ARM because the worst case is unlikely and maybe rates will decline. Others may prefer the fixed-rate loan because they want the stability of unchanging principal and interest costs. Whatever their choice, with potential cash totals in front of them borrowers will at least have better data from which to work.

Moreover, why not individual disclosures for individual loans? In the computer era that’s surely not a difficult task and it should be no problem for lenders to program computers to print out personalized disclosure forms standardized disclosure warnings as well as actual loan data.

The Baucus Bill
Isn’t there a better way to create usable and understandable loan disclosures? Absolutely. As an example, consider the single-page form originally proposed by Alex J. Pollock of the American Enterprise Institute. It’s now incorporated in H.R. 3012, the “Fair Mortgage Practices Act of 2007” sponsored by Rep. Spencer Bachus (R-AL).

If there is one bit of information that I would add to these forms it is the name and license number for the loan officer who originates the mortgage. Why? Because this way lenders and investors would be able to tell which loan officers produced reliable loans — and which ones had a high level of foreclosure. For a sample version of how such a form might look, press here.

“Given the enormous value of full and complete loan disclosures, such information should be part of every mortgage presentation, just like a good faith estimate of closing costs,” says James J. Saccacio, chairman and chief executive officer of RealtyTrac, the Internet’s largest source of foreclosure information. “Such disclosures should also be part of every loan application, whether subprime, Alt-A or prime. As the Federal Trade Commission has found, better disclosures help all borrowers, regardless of their credit standing.”
Columnist Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 100 newspapers.

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