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Several Ninth District banks introduced, or reintroduced, adjustable rate mortgage (ARM) loans recently. Regulations around ARMs have important distinctions from other mortgage loans, many of which have changed over the past few years. We discuss key consumer requirements unique to ARM loans and conclude with some references to help your institution comply with the requirements.
Disclosure requirements for ARM loans
Banks should make sure they understand key disclosure requirements for ARMs before issuing them. These requirements include but are not limited to the following:
Calculating the annual percentage rate (APR) for ARM loans: Some banks get tripped up by ARM calculations for loans where the introductory rate is not based on the note’s formula; the formula rate is considered the fully indexed rate. For example, a bank might offer an ARM with an introductory rate of 2.5 percent for the first six months, even though the fully indexed rate under the contract at origination would be 3.25 percent. In such a case, a blended APR must be disclosed. This blended APR reflects multiple payment streams: one payment amount based on the introductory rate for the time it is in effect under the contract and another based on the fully indexed rate for the remaining term. In our example, then, where a 30-year ARM has an introductory rate of 2.5 percent for six months and a fully indexed rate of 3.25 percent, the loan would have an APR based on six payments at 2.5 percent and 354 payments at 3.25 percent.
Interest rate and payment summary for ARM loans (effective 2011): Regulation Z requires creditors to present interest rate and payment information for mortgage loans in a table. The table for ARM loans shows the payment under specific interest rate scenarios. Many banks typically show the rate at consummation, the maximum rate in the first five years (beginning at the first payment date) and the maximum rate that may apply during the life of the loan. These disclosures help show the borrower the contractual impact on the loan payment if the interest rate increases rapidly.
Other disclosure requirements for ARM loans
Customers must receive disclosures for ARM loans that are not required for fixed rate mortgage loans. They receive an ARM program disclosure that describes the product’s terms and features when they request an application. Borrowers also receive subsequent disclosures alerting them at the time of the initial interest rate change and again whenever a change in the payment amount occurs. Banks must send notifications in advance of the rate change and include information about the new payment amount and interest rate. Amendments to Regulation Z effective in January 2014 changed the timing and content of the adjustment notices.
Other disclosures required in mortgage transactions, such as the good faith estimate under the Real Estate Settlement Procedures Act and the private mortgage insurance disclosures under the Homeowners Protection Act, differ from fixed rate disclosures because of an ARM loan’s variable rate.
ATR requirement for ARM loans (effective 2014)
The ability-to-repay (ATR) determination differs for ARM loans compared to other mortgages because an ARM loan’s payment may change. Most significantly, a creditor evaluates a borrower’s ATR by considering income, assets and debt obligations, including the monthly payment of the new loan. To determine ATR on an ARM, banks must:
- Use substantially equal monthly payments that would fully amortize the loan over its term, even if the contract terms require a different payment from the borrower.
- Calculate the monthly loan payment for purposes of ATR using the greater of the fully indexed rate or the introductory rate.
As an example, assume that the fully indexed rate on a 15-year ARM loan is 3.75 percent and the introductory rate for the first 12 months is 4.35 percent. The bank must use the introductory rate of 4.35 percent in calculating substantially equal monthly payments that amortize the loan over the 15 years to determine ATR.
An electronic version of the regulation, commentary and appendixes is available at http://www.consumerfinance.gov/eregulations/1026
