Flexible-payment adjustable-rate mortgages (FPARMs) are for borrowers who need low payments in the early years. The minimum initial payment is calculated at the interest rate in month 1, which can be as low as 1.25 percent, and rises by 7.5 percent a year.
While the interest rate jumps in month 2, the initial payment holds for the year. In the four years that follow, each minimum is 7.5 percent higher than the minimum in the preceding year. The rate in month 1 thus determines the minimum payments for the first five years.
Typically the payment will not cover the interest after month 1, resulting in an increase in the loan balance for some years. Under favorable conditions, the 7.5 percent increases in minimum payment over the first five years will suffice to pay off the larger balance and no larger payment increases will be needed. But there are no guarantees. If the increase in loan balance is too large, the borrower will receive a nasty surprise at the end of year 5: “payment shock.” In FPARM contracts, the payment is “recast” in month 61 to be fully amortizing over the remaining 300 months, regardless of whether or not the required payment increase exceeds 7.5 percent. In fact, payment shock could happen before the end of the fifth year if the loan balance reached a negative amortization maximum – a ceiling on how large the balance can become.
The likelihood of payment shock for any borrower making the minimum payments depends primarily on three factors:
Borrowers and lenders have no control over changes in the interest rate index, but the margin and the interest rate in month 1 are set in the FPARM contract.
In assessing the risk of payment shock, I looked at how payments would change on a 30-year FPARM that used the COFI index with a value of 1.909 percent at the beginning. I assumed two interest rate scenarios, one stable, the other rising moderately; start rates of 1.25 percent, 1.95 percent and 2.95 percent; and margins of 2 percent, 2.75 percent and 4 percent. The full results are shown in the Web version of this article.
I was surprised to find that even with a stable interest rate scenario, borrowers who took the lowest start rate or paid the highest margin were heavily exposed. A borrower with the lowest start rate of 1.25 percent and the highest margin of 4 percent would face a payment increase of 53.6 percent in month 61. Raising the start rate to 1.95 percent and 2.95 percent would reduce the increase to 36 percent and 14.6 percent, respectively. Lenders should not be offering combinations that result in payment shock in a stable rate scenario. Start rates of 1.25 percent should be limited to borrowers who command a margin of 2 percent, while borrowers who pay 4 percent or more should receive start rates no lower than 2.95 percent.
Any realistic assessment of payment shock exposure must consider the possibility that interest rates will increase. The scenario I used simply reversed the recent decline in COFI. From a high of 5.617 percent in December 2000, COFI dropped to an all-time low of 1.909 percent in October 2003. This decline of 3.708 percentage points took 34 months. To make the computations a bit easier, I cut the increase to .1 percent a month for 33 months, or by 3.3 percentage points in total. This modest increase is very far from being a “worst case.”
The results are scary. At the highest start rate of 2.95 percent and the lowest margin of 2 percent, the borrower would be hit with a payment increase of 31.6 percent in month 61. That’s the best outcome I found. At the lowest start rate and the largest margin, the payment would jump by 139.6 percent in month 36! Other results fell between these limits.
Bottom line: don’t be dazzled by a low initial rate that gives you the lowest initial payment. It also gives you the largest exposure to future payment shock. In shopping, focus on the margin first, then the maximum rate, then points and fixed-dollar fees. FPARMs are relatively easy to shop because, unlike other mortgages, which are repriced every day, FPARMs are repriced only occasionally. This means that borrowers can afford to be deliberate in canvassing the market for the best deal.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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