Devolving ARMs

“The Federal Home Loan Bank Board is again actively advocating variable interest rate mortgages. With a variable interest rate, mortgage on your home, the interest could be changed during the life of the mortgage. A home seeker’ examining variable interest rate mortgages should ask: ‘What’s in it for me?’ The answer is not much.” Consumer Benefit Doubted in arms, The Washington Post, March 8, 1975

Since they were first introduced, adjustable-rate mortgages have been the subject of considerable criticism and concern. The worry? A worse-case situation that would sink millions of ARM borrowers with high monthly costs and bloated loan balances.
Such dire predictions have largely been avoided, but new worries are emerging that old criticisms may be right and that ARMs are fundamentally dangerous — not just ARMs for subprime borrowers — but all ARMs.

Until recently ARMs had enjoyed decades of widespread acceptance. The reason had little to do with the basic ARM concept — an ARM is a mortgage with rates and payments that can change over time. Instead, ARMs have benefited from an astonishing run of good fortune in the marketplace.

Interest Rates
Over a 20-year period effective ARM interest rates fell substantially, from 10.87 percent in 1985 to 5.53 percent in 2005. This significant rate decline produced two major protections for borrowers: First, monthly payments generally fell over time, making homes more affordable and reducing potential foreclosure levels. Second, negative amortization was avoided because monthly payments were large enough to cover interest costs and principal reductions.
Negative amortization?

We usually associate mortgages with plain old vanilla “amortization,” the process of paying off a loan over time with monthly payments. If you have a 30-year self-amortizing mortgage, then at the end of the loan term you owe nothing, the mortgage debt and all required interest have been paid in full.

Negative amortization works differently. If you have an ARM and the monthly interest cost is greater than the monthly payment, unpaid interest is added to the loan balance. For instance, if you pay $1,000 a month but the actual interest expense is $1,200, then $200 is added to the debt.

Because interest rates largely declined until 2005 negative interest was rarely an issue. However, as rates have risen since 2005 negative amortization has become a worry for two reasons: First, a larger loan balance means bigger interest costs as well as more to repay if a home is sold or refinanced. Second, ARM contracts do not allow negative amortization to continue forever. Once loan balances increase to 110 percent, 115 percent or another set figure, the lender has the right to call the loan if the borrower cannot bring down the loan balance.

Home Prices
Not only have falling interest rates generally protected borrowers, another factor has been very much in their favor: In most markets if you had to sell you could sell at a profit.

In the period between 1973 and 2004 typical home prices nationwide rose from $30,900 to $211,700. Some of this increase merely reflected inflation, but because prices grew faster than the rate of inflation most property owners gained real wealth.

In the past year or so the situation has changed. The ultimate “out” for owners burdened with rising monthly payments — the ability in most markets to quickly sell at a profit — is no longer there for too many borrowers.

The New ARMs
Much attention has been given to the introduction during the past few years of such toxic loan products as option ARMs and interest-only mortgage financing. However, in addition to new loan formats something else has changed: In a quiet and subtle way traditional ARM products are increasingly unavailable.

In a traditional ARM, borrower protections against soaring rates might have included the following:

  • A payment cap which limited monthly payment increases to 7.5 percent per adjustment. If a loan payment was $1,200, then it could not be increased to more than $1,290.
  • A periodic interest rate cap which limited the amount interest could increase with each adjustment to 2 percent. If the starting interest rate was 6 percent the rate could not be increased to more than 8 percent when the loan was adjusted, perhaps every year or six months.
  • An exception for recasting. With a typical ARM the monthly payment can be “recast” every five years to assure that the loan is being paid down on a self-amortizing basis. The periodic interest rate cap does not apply when a loan is recast.
  • A lifetime interest rate cap, generally no more than 6 percent over the original interest level. If a loan has a 5 percent start rate than the highest rate can be 11 percent.

Traditional caps might be described as “2/6” — an ARM with a 2 percent periodic cap and a 6 percent lifetime cap. Now, however, caps are more likely to be described this way: “2/5/6.”
Huh? Where’d the “5” come from?

The “2” is the periodic cap, the “6” is the lifetime cap and the “5” is something new, an initial adjustment cap.

“But wait a minute,” you might say, “an initial cap of 5 percent is a lot more than 2 percent. Won’t many ARM borrowers face a tremendous payment shock if rates rise more than 2 percent?”
You bet.

“For example,” say federal regulators, “ARMs known as ‘2/28’ loans feature a fixed rate for two years and then adjust to a variable rate for the remaining 28 years. The spread between the initial fixed interest rate and the fully indexed interest rate in effect at loan origination typically ranges from 300 to 600 basis points.”
“It’s not necessary for interest levels to jump 5 or 6 percent in one shot for borrowers to face massive payment shock. Far smaller rate increases can easily cause people to lose their homes,” says Jim Saccacio, Chairman and CEO at, the nation’s leading foreclosure marketplace.

“What’s really happened is that the definition of an ARM has changed over time,” Saccacio explains. “The use of high or unlimited initial cap rates means many homeowners will be jolted into foreclosure and bankruptcy as loans reset. It would certainly make sense for regulators to say that initial reset rates can never be higher than periodic caps — and that rates cannot be changed more than once a year.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.

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