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   ARTICLE   |   From Scotsman Guide Residential Edition   |   November 2005

The Lowdown on Low Rates

Understand the latest products to keep from lowering your credibility

r_2005-11_Morgan_spotAdvertisements for low introductory rates for mortgage loans abound in newspapers, direct mail, radio, the Internet and more. These low rates seem unbeatable and can excite and entice borrowers — but these programs can be detrimental to the livelihood, investment and future of some borrowers.

As a mortgage professional, an essential way for you to build and maintain credibility with customers is to fully understand all programs, particularly the eye-catching interest-only and teaser-rate ARMs that have recently risen in popularity. Borrowers, especially those who are uninformed, look to their mortgage professional to help them decipher industry jargon and to determine if these loans are right for them.

Let’s take a closer look at a few of these ARMs. Loan officers who offer a one-year ARM can help their borrowers understand that the interest rate will change every year. But when borrowers hear about a 1-percent, one-year ARM offer, they cannot believe it. Because the public has been taught that lower interest rates are better, these borrowers may be compelled to request the low-rate product. How different could the terms be?

In this case, the terms are quite different. A one-year ARM offers an interest rate that is fixed for one year. The 1-percent, one-year ARM, on the other hand, offers payments that are fixed at the 1-percent level, but this does not reflect the fact that the underlying interest rate is changing. The introductory-rate and subsequent payment-rate changes are based on the payment rate, not the interest rate. The deficit between the payment rate and the actual interest-rate-carrying cost on the loan can result in principal being added back to the loan — known as negative amortization.

A borrower’s loan balance may increase far more dramatically with deferred interest than it will decrease with amortization. This is because negative amortization is compounded interest — interest on interest. While this may not be horrific in and of itself, this is what happens when interest rates increase only moderately, at the rate of 1 percent per year. In today’s rising short-term interest-rate environment, rates are likely to rise much more rapidly than that, adding more to the loan balance.

The differences in these programs can be confusing and misleading for borrowers. By helping borrowers understand the details, mortgage professionals become the experts, thus building trust, credibility and increased opportunities for referrals.

When teaser rates are a good option

In theory, there is nothing wrong with suggesting a teaser rate to borrowers who might benefit from it. But you must first get to know your borrower well. For instance, it is a time-tested strategy for borrowers to take advantage of a low-interest period to pay additional amounts toward the principal, especially when they can identify a finite period of time for the loan.

Many loan officers advocate the use of the teaser-rate ARMs to bridge particular situations, such as:

  • Investors purchasing a property to sell in a short period of time;
  • Borrowers purchasing a home who have to make two mortgage payments (old home and new home) for a defined period of time;
  • Borrowers who believe their home will appreciate faster than the loan balance accrues, and therefore  borrow from appreciation to offset deferred interest; or 
  • Borrowers who are using the option ARM as a modified version of a reverse-equity loan.

These are all rational justifications for pursuing this type of loan. Experienced borrowers will appreciate multiple options — amortized, interest-only or deferred interest — for making payments. They are typically aware and capable of handling the consequences of each option.

Uninformed borrowers, on the other hand, may choose a product simply for the low payment, not realizing that the pace of negative amortization could sweep the equity away from the property, even at a high rate of appreciation.

The option ARM, with three payment options, suits particular borrower situations, such as:

  • Borrowers with variable income who receive most of their income at sporadic intervals, such as attorneys receiving annual or quarterly distributions; or
  • Seasonal business-owners or workers, such as landscape or pool contractors. They can benefit from the low cash-flow requirement in the winter months.

As mortgage professionals assist borrowers in selecting the right loan, it is important to understand both the drawbacks and benefits to potential negative loan balances to paint the big picture for customers.

The drawbacks

  • Prepayment penalties: Option ARMs normally have a prepayment penalty to prevent borrowers from refinancing within the first two or three years. Being saddled with negative equity and being unable to refinance to more-favorable loan terms tends to exacerbate the impact of a loan and can become unaffordable for borrowers.
  • Negative amortization cap: The loan balance can grow as deferred interest gets added to the principal balance. This cannot proceed unabated, and lenders normally cap the negative amortization at 110 percent to 125 percent of the original principal balance. Once this cap is reached, new monthly payments are established as a fully amortizing loan. Even if the negative equity balance is not attained, many loan documents require that the loan be recast every five years.
  • Subordinate liens: Many second-trust lenders are unwilling to accept a second lien behind a loan that could erode the equity in the house. At best, lenders will determine if there is any “lendable equity” if the loan reaches its full potential negative amortization and base their loan-amount calculations on this amount.
  • Homeowners’ and title insurance: Title-insurance policies must offset potential negative amortization and will include a rider that protects the loan up to its full potential balance.

The benefits

  • The margin: Ultimately, if a monthly loan offers a favorable margin, it may still be a competitive choice over longer-term loans. This should be compared to the other interest-only ARM products available, such as the 3/1 or 5/1 ARM. For example, a 5/1 ARM may offer an introductory rate of 5.75 percent. If the monthly option ARM had an index of 3.04 and a margin of 1.75, then the fully indexed rate — or real interest rate — would be 4.79 percent. In this situation, a borrower who is aware of the monthly option ARM’s features might choose that loan rather than the 5/1 ARM.
  • Low risk for the lender: Lenders assume the risk of rising or falling interest rates that affect the value of their investments. In the case of the option ARM, lenders take virtually no interest-rate risk. Therefore, lenders are able to absorb more credit risk on an actuary basis. As a result, these loans may offer more-expanded criteria than other investment-grade loans.

In the mortgage business, as in many industries, building credibility with customers is invaluable. Being knowledgeable, aware and dedicated to servicing borrowers in the manner most ideal for them not only ends with closed loans, but begins future relationships with their friends, families, coworkers and acquaintances.


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