MLO Mentor: The adjustable-rate mortgage, Part II

MLO Mentor is an ongoing series covering compliance best practices for mortgage loan originators (MLOs). This article discusses 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

An 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 which created demand for all types of mortgages, ARMs are typically very popular when housing prices are high, or FRM interest rates are high. In the past, ARMs allowed borrowers to leverage the lower interest rate on an ARM, or even the initial teaser rate, into a higher purchase price.

In addition to the greater purchasing power they initially provide a borrower, ARMs may attract borrowers who plan on:

moving within the fixed period of the loan;
refinancing the loan into a lower rate after they improve their credit; and/or
using the money saved by the lower ARM interest rates in higher-yield investments.

Unfortunately, these plans don’t always bear 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 house securing the property had lost value, or the borrower had lost their job.

Additionally, the terms on some of the more creative ARMs also contained time-bombs which, when the time came for a refinance, blew up in the borrower’s face.

All ARMs contain these four items:

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

The introductory interest rate

The introductory interest rate is the initial rate on the ARM. The introductory interest rate is sometimes called a teaser rate. This rate stays fixed for a set amount of time, called the introductory period. The introductory period can be anywhere from a month to ten years, depending on the type of ARM.

Lenders may set the introductory interest rate at a discount of the index, or however it chooses, depending on whether it wants to attract borrowers for ARM loans. But in most cases, the introductory interest rate is lower than the rate which will be experienced during the remainder of the loan.

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

However, ability-to-repay rules (which became effective in 2014) require lenders to underwrite borrowers based on a fully-indexed rate, or the highest rate which may be possible on the ARM during the first five years of its term.

The index

The index is the first of two components which determine the adjusted interest rate after the introductory period. An ARM is said to be “tied” to an index. The index is basically a rate to which the loan adjusts. As the index rises and falls, so does the ARM’s interest rate.

ARM interest rate adjustments can be tied any one of a variety of indexes. Each index adjusts based on different criteria, set by the “owner” of the index. Common indexes for ARMs are:

11th District Cost-of-Funds Index (COFI);
12-month Treasury Average; and
Secured Overnight Financing Rate (SOFR).

The COFI is compiled monthly and based on the previous month’s cost of funds actually incurred by lenders. Given that the COFI is set monthly, it is appropriate for ARMs since it is a short-term benchmark.

The 12-month Treasury Average is released as a weekly average by the Federal Reserve Board. It is based on the average yield on Treasury securities with 12 months of their maturity remaining. This yield is based on the amount paid by winning bidders on Treasury Securities in the over-the-counter stock market.

Conspicuously missing from the list of common ARM indexes is the London Inter-Bank Offered Rate (LIBOR). LIBOR was the index of choice until 2021 — but is now being discontinued. The last one-week and two-month LIBOR settings were published on December 31, 2021. The Intercontinental Exchange will continue to publish one-month, three-month, six-month and twelve-month LIBOR settings through mid-2023. This extension will give existing contracts a further opportunity to end or be restructured.

With the LIBOR’s demise, the backup rate of choice is the Secured Overnight Financing Rate, administered by the Federal Reserve Bank of New York. Unlike the LIBOR, the SOFR is less susceptible to manipulation and fraud. This rate is based on completed transactions, specifically on overnight funds collateralized by treasury securities.

For housing, homebuyers choosing ARMs have already started seeing the SOFR in their notes. Beginning in 2020, Fannie Mae and Freddie Mac’s regulatory agency, the Federal Housing Finance Agency (FHFA), has prohibited the purchase of any ARMs benchmarked to the LIBOR with maturity dates beyond the December 31, 2021 deadline.

The FHFA has also worked to help Fannie Mae and Freddie Mac transition to the SOFR. With greater reliability in the 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 of the change in the cost of lending.

Regulation D requires the index used to be:

readily available and verifiable by the borrower and beyond the control of the creditor [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 may not arbitrary, and opaquely, make changes to a consumer’s interest rate on an ARM. Changes are to be made in a transparent fashion.

The margin

The margin is the second component which determines the adjusted interest rate after the introductory period. The margin is basically the points the lender adds to the index to make its profits. The margin varies per lender, but usually stays fixed for the life of the loan.

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

For instance, if an ARM had an index of 4%, and the margin was 2%, the fully-indexed rate would be 6%. If the index then fell to 2%, the fully-indexed rate would be 4%.

The adjustment interval

The adjustment interval is the time between changes in the ARM’s 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 will adjust to the current index, plus the margin. Thus, the monthly mortgage payment changes each time the ARM adjusts.

An ARM with payments scheduled to adjust every year is a 1-year ARM. An ARM with payments scheduled to adjust every three years is a 3-year ARM.

Armed with these ARM basics, real estate professionals can better inform their clients on the pitfalls of seductively low teaser rates. With mortgage interest rates climbing at an alarming clip, homebuyers may be swearing off FRMs altogether.

Because of the Federal Reserve’s response to inflation, FRMs are downright ugly compared to ARMs in 2022. Buyer beware — as the economy slips into an undeclared recession, the sweet introductory interest rate of today’s ARMs may turn sour tomorrow.