The Veridian Blog

Indices are used for Adjustable Rate Mortgages as a method of computing the variable interest rate that the borrower pays on outstanding balances.  In nearly all ARM loans, the variable rate is computed periodically as the sum of the current index value plus a fixed margin.  For example, Borrower John’s LIBOR-based ARM rate would be today’s 1-year LIBOR index of 0.9644 plus a fixed margin of 2.25% (as determined when the loan was originated), for a total fully-indexed rate of 3.2144%.  This sounds great, as it is a historic low, but remember that indices are variable and hence can, and will, go up at some point in the future.  This rate will adjust automatically on a yearly, semi-annual or monthly basis so the borrower’s monthly payment will also change automatically.

For hybrid-ARM loans that offer an initial fixed period, the terms will specify limits, or CAPS for how much the variable rate can  move once the loan converts, from period-to-period, and during its lifetime.  This is typically defined in three numbers: an initial cap, a period cap and a lifetime cap.  Borrower John’s caps are likely going to be “5/2/5”, which indicates an initial cap of 5% over the starting rate, 2% maximum increase from year-to-year, and a 5% cap over the starting rate at any time during the life of the loan.

The most common ARM indices used in the United States are:

1.      CMT – this is also known as the “1-year Treasury” or “1-year T-Bill”, it is the most widely used index.  Roughly half of all ARMs are based on the CMT with annual rate adjustments. 

2.      LIBOR – the London Inter Bank Offering Rate is an average of the interest rate on dollar-denominated deposits, also known as Eurodollars, traded between banks in London.   It is an international index which follows the world economic condition and is generally more volatile than the CMT and the COFI.

3.      COFI – the 11^th District Cost of Funds index reflects a weighted average interest rate paid by the 11^th Federal Home Loan Bank District savings institutions for savings and checking accounts, advances from the FHLB and other sources of funds.  COFI is the slowest moving and most stable of all ARM indices.

4.      Prime Rate – is the rate charged by nation’s largest banks for short-term loans to their most creditworthy customers.  Many home-equity loans and lines of credit, credit cards and auto loans are tied to the Prime Rate as published in the Wall Street Journal – which factors in at least 75% of the 30 largest U.S. banks.

5.      National Average Contract Mortgage Rate – formerly a popular index in the 1980’s, this represents the weighted average of initial mortgage interest rates paid by home buyers reported by a sample of mortgage lenders for loans closed for the last 5 working days of the month. 

6.      COSI – the Cost of Savings Index – is based on interest rates that a particular bank pays to individuals on certificates of deposits.  Since the merger of World Savings and Wachovia, only two indexes published by Wachovia and Wells Fargo are used consistently.

Lenders will usually offer lower rates on ARM programs because they are shifting the interest rate risk to the borrower.  For more information on ARMS and the different indices, email us or see: http://www.armindexes.com/index-types.html

Happy New Year Everyone!

The U.S. Department of Housing and Urban Development (HUD) issued new regulations under the Real Estate Settlement Procedures Act (RESPA) Regulation X, last year that are set to go into effect on January 1, 2010.  These important regulatory changes will place new requirements on lenders to ensure borrowers are better positioned to understand their mortgage transaction and terms of their loan. 

Key changes will include:

1.      Good Faith Estimate – now, the “new RESPA Reform Good Faith Estimate” (GFE), this can no longer be issued for pre-approvals as a property address is now required for the application to be complete.  The GFE must be issued no later than three business days after the loan originator receives an application.

2.      List of Service Providers – Borrowers must receive a list of service providers in the local area for any required settlement service for which the borrower can shop.  Not sure whether this will include appraisers at this point.

3.      Fee Changes – GFE must contain a total of the Adjusted Origination Charge and charges for all settlement services.  This is one amount that includes all lender and broker fees/credits involved in the transaction.  All lender and broker fees/compensation will be listed under one all-inclusive Origination Charge.  Settlement charges disclosed on the GFE must be accurate (within tolerances), both initially and throughout the application process. 

4.      Fee Tolerances – These have been established for variances between the GFE and HUD.  Unless there is a valid Changed Circumstance, lenders and brokers are prohibited from exceeding certain fee tolerances ranging from 0 to 10%.

5.      Changed Circumstances – A GFE may only be re-issued under this scenario, which does not include loan origination changes by lender/broker or transfer taxes.  More info on this to be developed in the future.

6.      Re-Disclosed GFE – Re-disclosure to the borrower must occur within three days of the event that led to the change.  For example, changes in credit, loan amount, property value or loan program.

Lending is not going to get any easier in 2010.  Based on the last few years, all of this is subject to revision and further changes.  Please contact us if you have any questions with the new laws.

The 5/1 ARM, tarnished for years by bad news press as one of the “exotic” loan programs blamed for the foreclosure crisis, is in our opinion an important loan program that can be extremely advantageous to the financially-savvy borrower.  Because of the unfair label, most moderately conservative borrowers these days opt for the traditional 30-year fixed program.  Part of the reason also is that we feel the 5/1 ARM is not properly or adequately explained to clients as it should be. 

The 5/1 ARM is a hybrid of long-term fixed programs and shorter term adjustable rate mortgages (ARMs).  The program offers a fixed rate and payment during the first 60 monthly payments, or 5 years of the term.  After the initial fixed period, the loan then automatically converts to an ARM which means the interest rate becomes variable for the remainder of the term.  I most cases, the rate will change every 12 months, or one year, based on the sum of a fixed margin and a given index - usually the 12-month T-Bill or the 1-year Libor.  This is the uncertainty that drives most people away – despite the initial low “teaser” rates as well as lifetime and period caps on rate increases.

We generally recommend the 5/1 ARM if the borrower intends on owning the house 8 years or less because that is our estimated “break-even” point after including many factors that most by-the-book lenders don’t: likely increase in income in 5 years (thus absorbing any payment shock), likelihood of refinancing or moving within 5 years (most people move sooner than they plan to), likelihood of paying down principal in 5 years, likelihood of rates going up and staying up in 5+ years (if rates skyrocket after 5 years, remember that the borrower has still built a 5-year cushion of savings).  In other words, it would take a combination of unfortunate occurrences for the decision to apply for the 5/1 ARM to be a financially incorrect one. 

Another factor to consider – the emotional component.  We realize that some borrowers, no matter what sort of analysis is offered, cannot sleep well at night if they do not know what payment is expected for the next 30 years.  And we understand that.  There’s no sense in trying to play the odds if you’re going to accelerate the aging process!

For even more detailed analysis of hybrid-ARMs, indexes and caps, let us know!