New mortgage rules the Consumer Financial Protection Bureau announced Thursday will change how lenders decide if borrowers qualify for adjustable-rate mortgages. The "ability to repay" rule, which goes into effect in January 2014, requires lenders to consider more than just the loan's initial interest rate in determining whether someone can afford the loan.
The new rules are intended to keep lenders from getting borrowers into mortgages they can't afford. Unlike regular fixed-rate mortgages that have the same rate and monthly payment throughout the life of the loan, rates on ARMs change, which can lead to larger monthly payments that make it harder for a borrower to afford the loan. Some observers say that ARMs played a role in triggering the housing-market collapse, when some homeowners found themselves unable to keep paying their mortgages as their rates adjusted upward.
Instead of using the introductory rate in their calculations, lenders will be required to consider the loan's "fully-indexed rate." This is defined as the margin the lender has on that loan plus the index the loan is pegged to. For instance, an ARM with a 225-basis-point margin (or 2.25 percentage points) that's pegged to the one-year LIBOR, currently at 0.84%, would have a fully-indexed rate of 3.09%. The lender will have to make sure the borrower has the ability to make the loan's monthly payments at this rate, even if the initial rate they're offered is lower than that. Currently, the fixed rate on a 5/1 ARM, which has a fixed rate for the first five years and adjusts annually after that, averages 2.67%, according to mortgage-info website HSH.com.
While many lenders already use the fully-indexed rate to approve borrowers, it's not a standard used throughout the industry. Some lenders are approving borrowers with a rate that may be slightly higher than the starter rate but less than the fully-indexed rate, says Mark Goldman, senior loan officer with C2 Financial Corp, a San Diego-based mortgage brokerage firm.
For borrowers the new rule could make it harder to qualify for ARMs since all lenders will be using rates that are higher than the initial rate available on this loan. Experts say it could lead to fewer ARM originations once the rule is implemented.
The changes come at a time when ARMs are popular with many borrowers. Roughly $138 billion in ARMs were originated during the first nine months of 2012, slightly below the same period a year prior, but up 29% since they hit an annual low in 2009, according to Inside Mortgage Finance, a trade publication. Borrowers have been signing up for these loans because their initial rates are lower than fixed mortgage rates. Lenders, in particular those who've held these loans on their books, have been more eager to offer them because they stand to profit once rates do rise: at that point, they'll be getting bigger interest payments from ARM borrowers.
Given the risk of rising rates, some industry analysts say the CFPB's rule doesn't go far enough. The fully-indexed rate is not the highest rate an ARM borrower can incur. In fact, the lifetime cap on an ARM can be much higher.
Consider a 5/1 ARM. During the sixth year of this loan, the maximum amount the rate can increase by is up to five percentage points. So, a 5/1 ARM doled out with a 2.67% rate could rise to a maximum of 7.67%. Each year after that the rate can move by two percentage points, though it cannot surpass 7.67%. Ignoring this cap is "absolutely a concern," says Keith Gumbinger, a vice president at HSH.com.
Experts say it's possible that borrowers who are getting ARMs now could hit those limits after their loan adjusts. With rates expected to pick up at some point, borrowers in ARMs could be stuck with much larger monthly payments if they can't sell their home or refinance. "It could happen now more than in the past because we're starting out with rates that are incredibly low," says Stu Feldstein, president at SMR Research, which tracks mortgage data.
By AnnaMaria Andriotis