Are ARM mortgage interest rates about to rise?

The Consumer Financial Protection Bureau has come out with a new approach to mortgage financing, good faith estimate forms (GFEs) that are supposed to be better than the form introduced by HUD in 2010.

This is important stuff for three reasons: First, HUD estimates that the 2010 GFE saves borrowers $700 per loan. Second, when a lender hands you a good faith estimate it’s a commitment to deliver a mortgage with certain terms and conditions once all application requirements have been met, say a 5 percent interest rate and not 6 percent by the time you get to closing. Third, you can check the lender’s promises at closing because the numbers from the GFE are used to complete the official settlement document, the HUD1.

In terms of graphics and layout the proposed CFPB forms — Prototype A and Prototype B — are well designed. There’s no doubt they’re easy to read and that they explain in plain language how a proposed mortgage will work. Kudos to the designers.

But while the CFPB has asked the public to comment on which design it prefers, the forms can easily be viewed as suggesting new and higher loan costs for borrowers — precisely what the new consumer bureau was designed to avoid. How? Not because of the form’s design characteristics but because of the numerical examples they illustrate.

Interest Caps

The model forms describe the terms for a 30-year ARM. The loan amount is $216,000, the start rate is 2.5 percent and the highest possible rate is 10 percent.

The forms also tell us that the interest rate can rise by as much as 3 percent after two years and 3 percent each year thereafter until the 10 percent maximum is reached.

These numbers are a gift to the worst lenders in America and describe a loan that’s simply awful. The government itself does not allow such terms for the mortgages it insures under the FHA and VA programs. Moreover, most private sector lenders — to their credit — do not demand such terms.

Most ARMs have a 2 percent annual interest rate cap and a 6 percent lifetime interest increase cap. To further clarify their terms, many ARMs also have an additional cap, a limit on the first adjustment after the start rate ends. Thus you might see an ARM with caps described as “2/6” or “2/2/6.”

What the CFPB is describing is a 2/28 ARM with caps set at 3/3/7.5. In other words, the rate is fixed for the first two years of the loan term and then adjusts. Depending on rates at the time of the adjustment, the interest rate can rise or fall. In practice, the adjusted rate is likely to rise after the start because the initial interest level is deliberately set low to attract borrowers who might otherwise prefer a fixed-rate loan.

Why do lenders want to sell ARMs more than fixed-rate loans? Because the risk of inflation — higher interest rates — is shifted to the borrower.

So is it a big deal if the maximum rate can grow by 3 percent instead of 2 percent? You bet.

$216,000 ARM Mortgage
Start Rate 2.5 percent 2.5 percent
Initial Monthly Cost for Principal & Interest $853.46 $853.46
Annual Loan Cost For Principal & Interest $10,241.52 $10,241.52
Cap Increase Starting In Year 3 2 percent 3 percent
Starting Balance, Year 3 $206,081.42 $206,081.42
New Interest Rate 4.5 percent 5.5 percent
New Payment For Principal & Interest $1,079.82 $1,203.45
Annual Loan Cost For Principal & Interest $12,957.84 $14,441.40
To Calculate, See: Amortization Calculator
Copyright 2012 OurBroker.com. All Rights Reserved

It’s possible, of course, that interest rates will not increase to the allowable maximums. However, the risk to borrowers if rates increase is enormous, especially in an environment where household incomes have been falling. Here’s why:

With the 2-percent increase annual costs can rise by as much as $2,716. If the maximum increase is 3 percent then the annual loan cost can grow by as much as $4,200. The larger increase can be as much as $1,484 per more year higher than the 2 percent standard.

Are these big increases? In many households the answer is yes. Are these increases large enough to lead to foreclosure? Unfortunately, in many households the answer will again be yes.

The situation, of course, can get decidedly worse. In year four the “better” loan can have another 2 percent increase and a third 2 percent increase in year five. That means the highest rate can grow to 8.5 percent in this example. For the loan that allows the 3 percent increase, the rate can grow to 8.5 percent in year four and 10 percent in year five, the lifetime cap.

The CFPB is on the right track. Consumer representation is a great concept, it’s long overdue and the Bureau is also new and untried. The Bureau will make mistakes. Big deal. Let’s have some perspective: The failure of existing regulators to adequately police lenders virtually bankrupted the country.

The CFPB is asking for public input, so why not do what existing regulators do and pay for a few hours of outside help?

Oh, and more thing, the forms have still another flaw. A huge flaw. But that’s a matter for another conversation.

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Posted in: Mortgages

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