A flexible payment ARM (FPARM) is an adjustable rate mortgage that allows (but
does not compel) borrowers to make very low initial mortgage payments that rise
over time. The major drawback is that those who select the minimum payment option
may suffer "payment shock" – a sudden and sharp increase in the payment
for which they are not prepared.
FPARMs are also very complicated, which creates a danger that borrowers will
take them without fully understanding the risks. Borrowers who don’t understand
FPARMs, furthermore, may overpay, which increases the risk of payment shock.
The main selling point of FPARMs is the low payment in the early years. This
allows borrowers to buy more costly houses, or use the monthly payment savings
to pay down other high-cost debt, make home improvements, invest in the stock
market, and on and on. Loan officers and mortgage brokers selling FPARMs have
long lists of ways to use the cash flow savings. They may provide little information,
however, about how FPARMs work and what the risks are.
Rate Changes on a FPARM
The initial interest rate on a FPARM is a "teaser", it can be as
low as 1.25%, but it holds only for the first month. In the second month, the
rate jumps to equal the "fully-indexed rate": the most recent value
of the index used by the ARM, plus the margin.
Consider an FPARM originated in October 2003 that uses COFI as its index, and
has a 2.75% margin. Regardless of what the initial rate in November was, the
rate in December was the value of COFI in October, which was 1.909%, plus 2.75%,
or 4.659%. Since the margin affects the rate in every month but the first, it
is much more important to the borrower than the initial rate.
The interest rate on an FPARM adjusts monthly, with no limit on the size of
interest rate changes except a maximum rate over the life of the loan. The maximums
generally range from 9.95% to 12% or higher. Almost all FPARMs, however, use
rate indexes that adjust slowly to market changes. COFI is one such slow-moving
index, others are COSI, CODI and MTA.
Payment Changes on a FPARM
The minimum initial payment on a FPARM is calculated at the interest rate in
month 1, and rises by 7.5% 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% higher than the minimum in the preceding year. The rate in month
one thus determines the minimum payments for the first 5 years.
However, the rule that the minimum payment rises by no more than 7.5% a year
has two exceptions. The first is that every 5 years the payment must be "recast"
to be fully amortizing. It is raised to the amount that will pay off the loan
within the remaining term at the current interest rate – regardless of how
large an increase in payment is required.
The second exception is that the loan balance cannot exceed a negative amortization
maximum. After the first month, the minimum payment usually will not cover the
interest due and the difference is added to the balance. All FPARMs have negative
amortization maximums, which range from 110% to 125% of the original loan balance.
If the balance hits the negative amortization maximum, the payment is immediately
raised to the fully amortizing level.
Either the recast provision or the negative amortization cap can result in
payment shock. For a borrower making the minimum payments, the likelihood of
payment shock is larger the greater is the rise in the interest rate index;
the larger is the margin; and the lower the rate in month one that established
the minimum payment.
Borrowers and lenders have no control over changes in the interest rate index,
but the margin and the interest rate in month one are set in the FPARM contract.
Results of Some Simulations
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% at the beginning.
I assumed two interest rate scenarios, one stable, the other rising moderately;
start rates of 1.25%, 1.95% and 2.95%; and margins of 2%, 2.75% and 4%.
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% and the highest margin of 4%
would face a payment increase of 53.6% in month 61. Raising the start rate to
1.95% and 2.95% would reduce the increase to 36.0% and 14.6%, respectively.
Lenders should not be offering combinations that result in payment shock in
a stable rate scenario. Start rates of 1.25% should be limited to borrowers
who command a margin of 2%, while borrowers who pay 4% or more should receive
start rates no lower than 2.95%.
Any realistic assessment of payment shock exposure must consider the possibility
that interest rates will increase. The scenario I used simply reversed the decline
in COFI from a high of 5.617% in December, 2000, to a low of 1.909% 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% 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% and the lowest margin
of 2%, the borrower would be hit with a payment increase of 31.6% 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% 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.
