In recent weeks, my mailbox has overflowed with messages of distress from borrowers faced with imminent rate adjustments on their adjustable-rate mortgages. Most of them want to refinance, but many of those who had taken 100 percent loans are stuck. With the current softness in the housing market, some now owe more than their homes are worth. Lenders are strongly resistant to refinancing loans with balances exceeding property values.
The great majority of the borrowers don't have a clue as to what is going to happen to their adjustable rates. They know it is going to go up, but they have no idea how much. Many of them assume that it is worse than it is, perhaps because this gives them an excuse for not doing anything to prepare.
If that describes you, it is time to shake the sand out of your eyes. While you can't know exactly what your rate will be on the adjustment date -- that depends in part on what happens to market rates between now and then -- you can know what your rate would be if the adjustment occurred today. Call this the current projected rate," or CPR. As the adjustment date gets closer, the CPR becomes an increasingly good estimate of the actual rate on the adjustment date. Use the CPR to plan your next move.
To calculate the CPR, you need four pieces of information from your note. The first is the interest rate index to which your rate is tied. Such indexes have names like COFI, LIBOR, CMT, MTA, CODI and prime rate. When you have identified the one used by your ARM, go to http://http://www.mortgage-x.com and find its most recent value.
The second piece is the margin, which is the amount added to the index to determine your rate. This is critical because it varies so widely, from 0.75 percentage points to 7 or more. Because it is not a required disclosure, most ARM borrowers don't know what it is until their rates are adjusted.
The other two pieces of information you need from the note are the adjustment cap, which limits the size of a rate change, and the lifetime maximum rate. Not all ARMs have adjustment caps, but they all have maximum rates.
The rate-adjustment rule is that the new rate will equal the most recent value of the index plus the margin, subject to the caps. Here are some examples:
? Current rate 5 percent, current index 5 percent, margin 2.75 percentage points, adjustment cap 3 percentage points, maximum 10 percent. The new rate is the index plus a margin of 7.75 percent; the caps are not a constraint.
? Current rate 4 percent, current index 5 percent, margin 2.75 percentage points, adjustment cap 3 percentage points, maximum 10 percent. The new rate is the current 4 percent rate plus the 3 percent rate adjustment cap, or 7 percent, which is below the index plus margin.
? Current rate 5 percent, current index 5 percent, margin 6 percentage points, no adjustment cap, maximum rate 10 percent. The new rate is the maximum of 10 percent, which is below index plus margin.
When the rate is constrained by the rate-adjustment cap, as in the second example above, the respite is only temporary. If the index value stays the same, the rate will increase to index plus margin at the next adjustment.
There would be a lot less confusion if the lenders servicing ARMs reported the CPR every month and the payment associated with it. They calculate it now, but only for the month preceding a rate adjustment. It would be simple to do it every month so that borrowers always knew where they stood.
No lenders I know of do that. It is symptomatic of the wretched level of service provided by mortgage servicing agents. (Note: If you service ARMs and do provide the CPR monthly, send me a copy of your monthly statement, and I will happily eat my words in public.)
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,http://http://www.mtgprofessor.com.
Copyright 2007 Jack Guttentag
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