Q: “What grade would you give the federal government in establishing disclosure rules for adjustable-rate mortgages (ARMs)?”
A: “F” for “flunk,” because the mandated disclosures exclude the essential information borrowers need to make decisions.
Borrowers contemplating an ARM ought to know: 1) how long the quoted rate will last, 2) what might happen to the rate and payment when that initial rate period ends, and 3) what might happen to the rate and payment in subsequent adjustments after the first one.
Most ARM borrowers know the answer to the first question, but many are at sea regarding the second and third questions. To answer them, they need to know: a) the rate index used by the ARM; b) the margin that is added to the index to determine the rate; c) the adjustment cap that may limit the first rate adjustment; d) the rate adjustment interval after the first adjustment; e) the adjustment cap on rate changes after the first change; and f) the maximum rate allowed by the ARM contract.
None of this information is a mandated disclosure (note: borrowers shopping negative amortization ARMs require even more information, but that can wait for another time).
Mandated ARM disclosures occur at three stages. The earliest and most general is provision of a Consumer Handbook on Adjustable Rate Mortgages (“Charm Booklet”). The handbook isn’t bad as a general education tool, but the checklist it provides for comparing two ARMs is incomplete and confusing.
The next level of ARM disclosure, provided to the borrower with the application form, is a list of items that must be disclosed “for each variable-rate program in which the consumer expresses an interest.” To comply, each ARM lender develops a library of ARM disclosures.
I have read many, which range in quality from excellent to execrable. There are no requirements for comprehensibility, and perhaps half of them would be beyond the capacity of most borrowers. But even borrowers capable of understanding the disclosures receive little help because the rate, margin and maximum rate in the disclosures don’t apply to the borrower’s loan. The description is of the same type of loan, not the same loan.
It is difficult to grasp how ridiculous this is unless you come into contact, as I do quite often, with ARM borrowers who close their loans without ever knowing what their margin is. Especially on option ARMs and home equity lines of credit (HELOCs), on which the initial rate usually holds for one month only, the margin added to the index is the price for the next 359 months. Yet the best the regulations can do is require the lender to remind the borrower to ask about it. Shameful.
The third level of ARM disclosure, designed to quantify the risks inherent in an ARM, require either historical or worst-case examples. The historical example shows payments and balances on a $10,000 loan for 15 years starting in 1977, the year preceding a marked rate increase. The worst case shows initial and maximum rates and payments on a $10,000 ARM if the rate rose by as much as the contract allowed.
This would be useful if the ARM involved in the exercise was the one the borrower was considering. It would even provide a rationale for not mandating the disclosure of the individual ARM features cited earlier. If the borrower knows how his mortgage would fare in a worst-case scenario, not knowing the ARM features is not that serious.
But neither the historical nor the worst-case example applies to the borrower’s loan! The historical example uses a “representative” margin, while the worst-case example uses the margin in effect when the lender developed the disclosures.
The full absurdity of this is also difficult to grasp. An analogous situation would be a consumer shopping for an automobile who asks about how the car fared in the government’s rear-end collision test. In response, the salesman provides the information for the model they were selling five years ago.
Why not use the actual margin on the loan at issue? Lenders evidently convinced the Federal Reserve that the disclosures had to be developed in advance to make them feasible, but this is nonsense. The technology for producing these kinds of disclosures using live-price data at the point of sale has been available for at least 15 years.
The sad conclusion is that the mandated disclosures try to do too much and end up accomplishing little or nothing. If all existing ARM disclosures were replaced with a requirement that lenders disclose the margin and maximum rate on the specific loans being offered, borrowers would receive more useful information than they get now.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
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