REQUIRED READING: Sometimes rules that are made with the best of intentions end up creating more problems than solutions. A case in point: the addition of a new notice to borrowers that have adjustable-rate mortgages (ARMs). As envisioned by the Consumer Financial Protection Bureau (CFPB), a new rule calls for a notice to be sent to the borrower 210 to 240 days prior to the initial scheduled rate adjustment. In other words, seven to eight months prior to the expiration of the fixed-rate period at the onset of the majority of ARMs.Â
The rule requires that servicers use reasonable efforts to 'estimate' what the new rate and corresponding payment will be at the upcoming adjustment. Outside of the additional burden being placed on servicers, one needs to consider if sending this new notice benefits the borrower in any way.Â
It is important to note that existing regulations already govern the disclosures required to be made to borrowers that have variable rate loans. The Truth in Lending Act (TILA) currently requires a notice be mailed at least 25 days prior to the adjusted payment becoming due, while Fannie Mae and Freddie Mac require an initial payment change notice to be sent 60 days prior to the effective date of a rate and/or payment change, with a subsequent notice mailed 30 to 45 days prior to the change.Â
As an example of the potential for consumer confusion, consider that the most common reference index used to calculate the interest rate on ARMs is the average weekly yield on U.S. Treasury certificates adjusted to a constant maturity. All Federal Housing Administration (FHA) loans reference this index, as well as a sizeable portion of conventional loans.Â
The key word here is ‘weekly’ – as in the index changes on Monday of every week. In practice, what this means is if servicers are forced to estimate the reference index rate seven to eight months in advance, the index will have 28 to 32 potential changes between when the consumer is given the information on the estimated new rate and payment and when the actual payment will go into effect.Â
In a normal environment, the index rates may not change drastically during that time, but even slight movements – particularly upward movements – will lead to borrower grumbling if the new payment ends up being higher than the servicer projected. This puts servicers in an extremely bad position.Â
Servicers may be forced to show several different scenarios in this new notice so that they can accurately account for upward ticks in the index. That will give the borrower even more data to digest and could lead to further confusion.Â
Other side effects of having such an early disclosure and payment estimation are still to be considered. For example, what if a borrower commonly makes excess principal payments each month? What unpaid principal balance should then be used in the payment estimation?Â Â
ARM and hammers
On the positive side, industry feedback to proposed changes was swift and vocal, and as a result, the CFPB has indicated a willingness to consider revisions to the proposed rule. One can surmise that the original intent of the ARM adjustment disclosure rule was to (1) give borrowers enough advance warning to take action should they feel that better (read: lower cost) borrowing options are available, (2) allow borrowers time to adequately prepare their monthly budget to account for any increase in the payment and (3) allow borrowers to start working with the servicer on options should any expected increase become unaffordable.Â
Each of those three goals are prudent, but under the current framework of the rule, the new disclosure may end up causing more consumer confusion and also lead to relatively drastic changes from what was 'estimated' seven to eight months prior to what the final payment number is calculated as of the rate and payment change date.Â Â Â Â
Perhaps the industry should consider if there are better ways to prevent payment shock. Most simply, if the CFPB wants to give borrowers more advance notice of a potential change to their interest rate, perhaps it would make sense to keep the 210 to 240 days notice, but without requiring a new rate or payment estimation.
Other ways to prevent payment shock could include setting rules around the maximum change percentage allowed at each adjustment and providing for standardization of ARM terms, such as the number of days in the ‘lookback’ period. Setting a standard lookback period of 45 days, for instance, would mean that servicers will be able to calculate the new interest rate a full two and a half months prior to the payment adjusting.
Lest we forget, the qualified mortgage rule issued on Jan. 10 effectively eliminates the kinds of exotic ARMs that were commonplace pre-credit crisis. It also requires lenders to underwrite the loans not only to ensure that the borrower is able to afford the payments during the fixed rate period, but also as the interest rate increases. This rule also frowns upon extremely low teaser rates that can cause payment shock or at ongoing rate adjustment periods.
Regardless of the final language contained in the ARM adjustment rule, servicers should be prepared to document total compliance not only with whatever revision the CFPB makes to TILA, but also with Fannie/Freddie/FHA requirements. Regular testing of loans should ensure compliance with disclosure mailing dates (including content of the disclosures), the calculation of the new rate and payment (including re-amortizing the loan), the new allocation of principal and interest, and any potential violations of the interest rate caps, floors and maximum periodic change.Â Â
The industry should praise the intention behind the proposed rule. However, the industry should hope that revisions will be made to avoid consumer confusion and help servicers keep their ARMs – both literally and figuratively.Â Â
Nick Volpe is vice president of capital markets and servicing at Agoura Hills, Calif.-based Interthinx. He can be reached at (818) 878-2800.