Lenders Put a Postcrisis Twist on the Adjustable-Rate Mortgage

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With interest rates climbing from the record lows of the last few years, adjustable-rate mortgages are making a comeback – with a variation known as the 5/5 getting special buzz.

ARM volume typically picks up when fixed rates rise, because the starting rates on adjustable loans are lower. This time around, however, borrowers may be more skittish about taking an adjustable loan. Many pundits have identified this class of loans as a cause of the mortgage crisis and are telling consumers to stay away from them.

The 5/5 ARM attempts to give consumers more certainty about what they will owe on their monthly bills in future years – splitting the difference between traditional ARMs and the more expensive, but lower-risk, fixed-rate loan. The product has become the talk of mortgage trade shows as a shrinking market challenges lenders to set their offerings apart to win the remaining business.

"We felt it was a product that made sense for our borrowers and obviously it is a way to differentiate ourselves," says Malcolm Hollensteiner, the director of retail lending products and services at TD Bank in Cherry Hill, N.J.

As the name implies, the interest rate on the 5/5 is fixed for the first five years, then adjusts once every five years for the remainder of the 30-year term. This is a safer proposition (from the consumer's point of view) than the more familiar 5/1, which is fixed for the first five years and adjustable once a year thereafter, the 10/1 (which some have compared the 5/5 to), and so on.

Another benefit of the product, from a portfolio lender's point of view, is that regulators prefer depositories hold adjustable-rate rather than fixed-rate mortgages.

"The regulators liked it from the standpoint that it is adjustable," says Kim Yarnelli, the vice president of member home loans at GTE Financial, a credit union which serves the Tampa Bay area.

The Mortgage Bankers Association's weekly application survey for the week of April 18 finds ARMs of all sorts making up 9% of all new loan applications. That's down from 32% for the same week 10 years ago.

Despite recent association with the subprime lenders that crashed and burned during the crisis, ARM loans tend to be the province of portfolio lenders such as banks, thrifts and credit unions. There are some secondary market purchasers for them but the product's origins go back to the 1980s when thrifts had an asset-liability mismatch, lending long-term at high rates and paying low rates of interest on short-term deposits.

"We are coming up on the 30-year anniversary for some of these venerable ARM products. They're not particularly dangerous. Do they carry a different risk profile than a 30-year fixed or any other FRM? Sure they do," says Keith Gumbinger, vice president at HSH.com, a mortgage research firm. "Can you go in and quantify what the risks are? Absolutely you can. You should go in and do these numbers and know what risks you face."

Pentagon Federal Credit Union, in Alexandria, Va., says it invented the 5/5, its signature product, and started offering it around Labor Day 2007.

However Gumbinger says 5/5 structures have been around since shortly after the ARM was introduced in the 1980s. The 5/5 and its cousin the 3/3 became "moderately popular" after borrowers became concerned over the fact that the rate on the one-year ARM can increase every year.

However, the 5/5 fell out of favor to the 5/25 (which was fixed for the first five years, reset and then adjusted every six months for the remaining 25 years) and 7/23 loans. "These were precursors to the hybrid stuff we know today," Gumbinger says.

Those familiar with the product agree the borrower is taking a gamble by going for the 5/5 versus an annually adjusting ARMs.

While the five years between adjustment periods do provide some certainty, if rates become very high, the borrower is stuck with that for the whole time, Gumbinger notes.

On the other hand, if rates continue to rise during years six through 10, the 5/5 borrower has won the gamble.

With rates in five years likely to be higher than they are today, the borrower's opportunity to refinance into a fixed-rate loan would be limited.

Then there are the adjustment caps and the life-of-the-loan caps that need to be considered.

PenFed's caps are two percentage points for the initial adjustment, two points for each subsequent adjustment and a total five points for the life of the loan.

Loan officers need to show borrowers comparisons of the various options and scenarios and figure out the worst case scenario, Gumbinger says.

"If your time frame is greater than five years, you are exposed to some risk. So you must go in with your eyes wide open and know what that risk presents to you and your budget," he states.

But there are borrowers who are comfortable with the stability offered by having another five years before the product adjusts again, says Craig Olson, PenFed's senior vice president for mortgages.

That five point lifetime cap is another attraction for borrowers. They're betting that rates will be more than five points higher after the third adjustment, if they have yet to refinance or pay off the loan.

To counter that gamble, PenFed offers a variation called the 5/5 ARM Rate Reset. With this option, for a quarter of a percentage point higher interest rate at the time the loan is originated, the borrower can elect to restart the five year loan term if rates decline.

PenFed is offering a limited time promotion where it will pay up to $10,000 in closing costs for 5/5 borrowers. The credit union is willing to lend up to $4 million.

Earlier this year, it introduced a 15/15 ARM to its customers. This gives consumers the benefit of a lower rate than the 30-year fixed-rate mortgage but without the steep monthly payment of the 15-year fixed loan, Olson says.

The core of the credit union's membership is military-related, with people who are likely to relocate several times during their careers. Shorter-term ARMs give them some of the security of a fixed-rate loan plus a lower interest rate.

GTE Financial has been originating 5/5 loans since 2010. Certain parts of its home market in the Tampa Bay area have million-dollar or greater properties.

"You have the safety and security that the rate will not adjust for that five year period. What we have found out is that when times are good, people will stay in a home five to seven years. We felt this was a perfect product for our market," says Yarnelli.

When it introduced the product, GTE only lent up to $750,000. It has now become so comfortable with the risk profile that it will lend as much $1.25 million.

GTE offers a two point adjustment cap and a five point lifetime cap. The credit union indexes the product to the London Interbank Offered Rate.

Today's ARMs are different than the products that dominated the market during the boom years. Even those products were not in and of themselves dangerous, Gumbinger says.

"It is that the risks that they presented were offered to audiences who could not manage those risks," he continues, referring to things like the option ARM.

Any ARM product has its intended audience. By nature, the ARM is a niche product, Gumbinger explains. They become a problem when the loans are offered to consumers outside of the profile.

TD Bank, a unit of Toronto-Dominion Bank, started offering 5/5 ARMs in September 2011 and does so for conforming limits as well as jumbo.

The ARM borrower is one who is focused on cash flow, says Hollensteiner at TD Bank. The 5/5 adds some security because the blended rate between years one to five and six to 10 is lower than the initial rate on a 10/1 ARM, he continues.

"Like any ARM, there is the unknown, but the unknown with the 5/5 can work out extremely favorable for a 10-year period." Hollensteiner says. TD Bank's product has a two point adjustment cap and a five point lifetime cap. But the first adjustment is subject to the lifetime cap.

TD Bank also offers a 15/1 ARM. While the bank is starting to see increased consumer interest in these loans, as long as fixed-rate mortgages remain in the low-to-mid 4% range, it is still a fixed rate market.

"This product and other ARM products will take off if and when fixed rates climb above 5.5%," Hollensteiner predicts.

Lenders who offered the wrong kind of ARM to the wrong borrower suffered during the downturn as well. As a result, when the inevitable default occurred, the lender could not recover most of the funds because the home fell in value.

While 30-year fixed-rate mortgages have their own risk, rising rates could make an ARM borrower more likely to default in the future, especially if a home doesn't appreciate as expected.

"The borrower loses his home, but the lender may end up with a home that's not worth the money he lent," Gumbinger says. "Lenders do need to keep this in mind as they consider offering these products. Some of these products feature risks that could cause them more headaches in the future." 

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