November 22, 2004
Adjustable rate mortgages (ARMs)
have always been a hard sell. ARMs have multiple features, which makes them
complicated, and complexity doesn�t sell well.
Most loan officers try to avoid
complexities by focusing on one feature that may attract the client�s interest;
this is the "hook". ARM hooks are almost always mortgage payments that are
relatively "low", or "stable", or "interest-only".
When more persistent borrowers ask
questions about the implications of low, stable or interest-only payments, the
response may be an "artful deception." The loan officer makes a correct
statement about the ARM, from which the client is allowed to draw an erroneous
conclusion without being corrected. The letter below illustrates one of the more
common artful deceptions.
"I am interested in an adjustable rate
mortgage (ARM) because it has a really low payment, but it does allow negative
amortization. When I asked the loan officer about this, he said that negative
amortization was limited to only 10% of the loan amount."
Negative amortization arises when
the mortgage payment is smaller than the interest due, with the difference added
to the loan balance. For example, if the interest due in month 1 on a $100,000
ARM is $600 but the payment is only $500, the balance in month 2 goes to
Since all mortgages must pay off
over their term, the balance on a negative amortization ARM must stop
rising at some point and start declining. And this means that at some point the
payment must increase to a level that will repay the balance over the
period remaining to term.
To make sure that this happens,
contracts covering ARMs that allow negative amortization contain a negative
amortization cap. The cap limits the amount of negative amortization to some
percent of the original loan, usually 10% or 15%. If the cap is 10%, for
example, the balance on a $100,000 loan cannot exceed $110,000.
Borrowers informed about a negative
amortization cap are allowed to think that it protects them in some way. Perhaps
they will assume that the lender will forgive the interest that is not covered
by the payment?
Not a chance! Negative amortization
caps are designed to protect the lender, not the borrower. When the balance
reaches the maximum, the payment is immediately raised to the fully amortizing
amount � the payment that will pay off the loan over the period remaining --
regardless of how large an increase that might be. The payment adjustment
cap, which usually limits the size of any payment increase to 7.5% per year, is
contractually overruled if the balance hits the negative amortization cap.
A negative amortization cap thus
provides no reassurance at all to a borrower contemplating a negative
amortization ARM. What the borrower should want to know is how large the payment
increase might be in the event that the negative amortization maximum is
reached. Unfortunately, very few loan providers have the inclination or the
capacity to answer this question.
"I have been offered an ARM at 2.5%
that is interest-only for 5 years. It sounds too good to be true�"
This letter illustrates another
artful deception used to market ARMs. The borrower considers the offer too good
to be true because she believes that she will have the 2.5% rate for 5 years. In
fact, the quoted rate held only for the first month.
The loan officer didn�t tell the
borrower that the 2.5% rate held for 5 years. The borrower assumed erroneously
that the interest-only period and the initial rate period were the same, and
nobody corrected her mistake � until she wrote me.
The purpose of this article is not
to dissuade anyone from selecting an ARM. The lower payments on ARMs in the
early years are attractive, provided that borrowers can handle the risk of
payment increases later on. ARMs that allow negative amortization provide the
lowest payments early on, and also the greatest risk of future payment shock.
The problem is that very few loan
providers offer any information bearing on how large the risk is. The prevailing
view is that any mention of risk is a downer that is going to discourage sales.
Borrowers must do their own risk assessment.
Information to Evaluate an Adjustable Rate Mortgage. Have the loan
officer fill it out for each ARM you are considering. Then use my calculator 7c
if it allows negative amortization, 7ci if it allows negative amortization and
has flexible payment options, or 7b if it is a no-negative amortization loan.
These calculators will allow you to see what would happen to the payment under
different assumptions about future interest rates.
Copyright Jack Guttentag 2004