Magazine article Mortgage Banking

ARMs: The Role of the Servicer

Magazine article Mortgage Banking

ARMs: The Role of the Servicer

Article excerpt

In today's competitive mortgage market, a variety of loan products offer the flexibility and variety that savvy borrowers demand. One such product, the option adjustable-rate mortgage (option ARM), is estimated by the Mortgage Bankers Association (MBA) to account for up to 10 percent of all current mortgage loans.

The option ARM provides borrowers the flexibility to choose how much of a payment to make each month. This flexibility, this power of choice, comes with a requisite amount of responsibility. Each choice has a result that must be contemplated by the borrower, ranging from paying down the loan to actually increasing the balance. The freedom borrowers have to select their payment option is what's driving the demand for this type of loan.

While originators continue to meet this growing demand, mortgage servicers take on an even larger role in maintaining this and other types of ARM loans. A servicer's role includes providing strong technical capabilities and sound operational processes, as well as offering borrower education on the nuances of ARMs throughout the product life cycle--especially as the reset rule approaches.

Mortgage borrowers can take advantage of various types of ARMs. Hybrid ARMs, for example, are a combination of fixed-rate and ARM loans. Interest-only ARMs, on the other hand, let borrowers pay only the interest portion of their monthly payment for a fixed period--usually three, five, seven or 10 years.

One of the most popular ARMs on the market today is the option ARM, which provides flexibility beyond a hybrid or interest-only by not requiring one set payment each month. Instead, borrowers get the choice of several monthly payment types: interest-only, 30-year amortized, 15-year amortized or minimum. With the minimum option, the monthly payment is generally set for 12 months based on a calculation set at origination; however, the interest rate could change, resulting in additional interest owed. In such instances, any unpaid interest is added onto the principal and the balance grows--this is called negative amortization. The interest-only option ensures that the interest, at least, is paid, thereby avoiding negative amortization. However, the loan balance is not reduced.

While these options are available to the borrower each month, two reset provisions require the monthly minimum to be adjusted to a fully amortizing payment, essentially eliminating the options for a period of time. The first reset is implemented at a predetermined negative amortization limit, typically 110 percent of the original balance. The other reset occurs every fifth year.

In recent years and as home prices have soared, more borrowers have specifically requested option ARMs to finance their home purchases. There are two common types of borrowers that normally gravitate toward ARMs: financially savvy borrowers and "cash-constrained" borrowers--often first-time homebuyers.

Financially savvy borrowers are experienced with investments, looking to increase available cash by reducing the amount dedicated for mortgage payments. Often, these borrowers obtain an ARM loan to pay off other debt or to make outside investments with specific financial goals in mind, possibly intending to "flip" their properties quickly. They are quite obvious about seeking the lowest payment possible, and are often very knowledgeable about its associated risks.

Cash-constrained homebuyers, on the other hand, often look to option ARMs as a way to enter a high-priced bracket, buying homes they may not otherwise be able to afford. Option ARMs allow this group to gain purchasing power, but the risks can sometimes outweigh the benefits. These borrowers may be enamored by the low payments and not question what may happen in the future.

Although much has been written on the role of originators with ARMs, the role of servicers has been less publicized. However, as the first large wave of ARM resets is around the corner, servicers are taking greater responsibility in educating borrowers--both the financially savvy and the less-experienced--about preparing for the risks of possible payment shock. …

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