MLO Mentor is an ongoing series covering compliance best practices for mortgage loan originators (MLOs). This article reviews the different types and features of adjustable-rate mortgages (ARMs). Enroll in firsttuesday’s 8-Hour NMLS CE to renew your California MLO license and learn more about fraud and abuse prevention in your practice.

Different ARM products

A plethora of ARMs exist, each with different terms. Common types of ARMs, or ARMs popular during the Millennium Boom include:

  • hybrid ARMs;
  • option ARMs;
  • conversion ARMs; and
  • interest-only ARMs.

ARMs provide lenders with periodic increases in their yield on the principal balance during periods of rising and high short-term interest rates. They enjoy greater demand when interest rates or home prices rise too quickly. Fewer buyers are able to qualify for a fixed rate mortgage (FRM) to finance their purchase. A graduated payment schedule allows buyers time to adjust their income and expenses in the future to begin the eventual amortization of the loan.

Hybrid ARMs

The hybrid ARM, also known as the “Canadian rollover,” is a fusion of a FRM and an ARM. It’s the “traditional” type of ARM in which the interest rate is fixed during the initial loan term, then adjusts periodically afterward. Some Hybrid ARMs are named after the initial fixed period and the adjustment period. The first number in the loan description references the period of the loan with a fixed interest rate.

The second number references the frequency of adjustments after the initial fixed-rate period (every year).

For example, one of the most common types of hybrid ARMs is the 5/1 ARM. With this type of loan, the interest rate is fixed for the first five years of the loan, typically at a low teaser rate. Then, the loan adjusts once a year after that initial period expires.

Other common hybrid ARMs using this naming convention include:

  • 3/1 (fixed for three years, then adjusts annually);
  • 7/1 (fixed for seven years, then adjusts annually); and
  • 10/1 (fixed for ten years, then adjusts annually).

Similar hybrid arms are intended for those with less-than-perfect credit. The initial rate is short to allow the borrower to qualify for a loan, with the intent of improving their credit and refinancing out of the hybrid ARM after the initial fixed rate. Common hybrid arms named under this convention are:

  • 2/28 (fixed for two years, adjustable for 28 years); and
  • 3/27 (fixed for three years, adjustable for 27 years).

2/28 and 3/27 ARMs may adjust every six months or every twelve months, depending on the terms of the mortgage.

Hybrid arms can meet the requirements for qualified mortgages, provided the underlying loan meets all other qualified mortgage requirements.

Interest-only ARMs

With an interest-only ARM, the borrower’s monthly payments are applied only to the interest due on the loan, not to the loan principal. This interest only payment schedule is typically for three to ten years. After the interest-only period expires, the borrower’s monthly payments are adjusted to include both interest and principal. However, because the borrower did not make any principal payments during the first few years of the loan term, the principal payments are amortized over a shorter period of time.

For example: A borrower enters into a mortgage agreement with a lender for an ARM which amortizes over 30 years. The terms of the loan provide for that the borrower will make interest-only payments for the first three years of the loan. After the three-year period expires, the lender will adjust the interest rate according to the terms of the loan, and recast the loan to amortize the borrower’s payments over the remaining 27-year period. (Note: some interest only loans also have periodic adjustments to the interest rate during the interest-only period.)

The longer the interest-only period, the greater the payments will be when the loan recasts.

Consider a borrower taking out a 30-year ARM with a five-year interest only feature. The borrower’s monthly payment during the first five years of the loan is $625. However, after the initial period has passed, the lender recasts the loan, raising the interest rate to 5% and amortizing the loan balance over the remaining 25 years of the loan. The borrower’s monthly mortgage payment jumps to $1,461 in the sixth year of the loan, more than double the amount of the borrower’s early payments.

Option ARMs

Option ARMs were among the most insidious type of loan offered during the Millennium Boom. Option ARMs are so named because under these loan terms, the borrower may choose from several different payment options each month. Also called pick-a-pay ARMs, option ARMs typically begin with a very low, teaser rate. However, this rate only holds for a month or so before increasing regularly every month.

Each month, the borrower may choose to pay:

  • principal and interest under a traditional amortization schedule for the full term of the loan (some Option ARMs allowed the borrower to choose the amortization schedule for the payment – 15, 30 or even 40 years);
  • interest only; or
  • a minimum payment, amounting to less than the interest due.

If the borrower chooses to pay the minimum amount, the unpaid interest due is added onto the total loan amount. This process in which accrued unpaid interest tacks on to the principal balance is called negative amortization. When the borrower chooses this payment option, their loan is recast after a certain number of years (typically five years) according to the new principal balance due—an amount now greater than the original loan. Payments caps do not restrict recast fully-amortized payments.

Additionally, these are still ARMs, so there is a chance that the loan will negatively amortize at ever greater amounts as the interest rate climbs and the amortization term shortens.

Another danger lies in the timing of the minimum payments. If the borrower makes minimum payments in the last few years of the loan, they may end up owing a large payment at the end of the loan term. This larger payment is called a balloon payment.

Some lenders placed negative amortization caps on loans which had the potential for negative amortization. The negative amortization cap places a ceiling on how high the principal balance was able to grow before a recast. This recast occurred at this ceiling regardless of any pre-set recast time period. The typical negative amortization cap was set at 110% or 125% of the original mortgage amount. And, as with other recasts, the payment caps did not apply.

Option ARMs were often a lure for under-qualified homebuyers during the years leading up to the financial crisis. Low-income borrowers consistently paid the minimum amount due each month. As a result, their debt quickly snowballed. When their loans were recast after origination, borrowers became overwhelmed with their adjusted payments. For borrowers who only paid the minimum amount, each recast would result in ever greater fully-amortizing payments.

ARMs use and forecast

Different types of ARMs fall in and out of favor with borrowers depending on the state of the housing market or current interest rates. During the Millennium Boom, overall ARM use was exceptionally high. In 2004, 33% of all mortgage applications were for ARMs. [Freddie Mac, 23rd Annual ARM Survey]

Editor’s note — Freddie Mac’s findings are based on its survey of prime loans.

In 2013, ARMs accounted for approximately 10% of all mortgages originated. This is on the lower end of historical ratios between ARMs and FRMs. Typically ARM use fluctuates between 11% and 30% of all mortgages originated annually. [Freddie Mac, 30th Annual ARM Survey]

For instance, the disparity between the 2004 ARM-to-FRM ratio and the 2013 ARM-to-FRM ratio is due to the type of borrower demand unique in 2004. During this time, many under-qualified borrowers were anxious to purchase property in the frenzied real estate market. However, these borrowers lacked sufficient income to make monthly payments on a 30-year FRM.

Because of this, many borrowers opted for high-risk ARMs. They expected the value of their collateral to only increase over the next few years, allowing them to either refinance or resell the property before their ARMs reset.

However, the value of borrowers’ collateral did not increase over the next five years; instead it dropped drastically. This prevented borrowers from escaping the obligations of their ARMs after the initial period of the loan. The implosion of real estate pricing was not just a shock to the real estate market, but to borrowers as well. Borrowers therefore reacted with much less favor toward ARMs in the years following the Millennium Boom and bust.

Hybrid ARMs remained the most popular type of ARM in 2013, with the 5/1 ARM leading the market, followed by the 3/1, 7/1 and 10/1 ARMs. [Freddie Mac, 30th Annual ARM Survey]

However, borrowers still prefer FRMs to ARMs. In 2018, many homeowners traded in their ARMs for FRMs. 94% of the hybrid ARM home loans refinanced by Freddie Mac in the second quarter (Q1) of 2018 were refinanced into FRMs, with only a relatively small 6% going back into another hybrid ARM. [Freddie Mac, Refinance Report Q1 2018]

ARMs have caused concern among government regulatory agencies in past years. In 2011, the Federal Reserve Bank (Fed) began requiring greater lender transparency with ARMs. Lenders making ARMs and other variable rate loans to homebuyers were required to provide disclosures that clearly detail the specific time and circumstances that will change the interest rate or payment schedule of a loan.

The Fed also required disclosures be made in plain language, laid out in a spreadsheet or chart format that clearly illustrates the risks of variable terms associated with the loan.

Under the guidelines, lenders must disclose that borrowers are not guaranteed the ability to refinance to a lower rate after their loan adjusts. Additionally, lenders are required to plainly state the maximum interest rate possible on the loan — a kind of “worst case” rate previously buried deep in the jargon of prior loan documents.

These requirements were present in the TRID disclosures when the CFPB took over responsibility for consumer mortgage disclosures.

ARMs are inherently riskier than FRMs and are often used by borrowers who overextend their finances. Their use fluctuates in reaction to the affordability of counterpart FRMs, and their respective rates.

Lower fixed rate mortgage (FRM) rates make ARMs less alluring to buyers. Further, long-term homebuyers still prefer the security of an FRM rate.