Part 1 of a 3 Part Series
For many years, we have experienced a low interest rate environment and originated predominantly fixed rate mortgages. Well times are changing – with the increase in interest rates, the popularity of Adjustable-Rate Mortgages is gaining momentum. We might be a little “rusty” in the process of originating and servicing ARMs. It’s time to brush the dust off of our ARM Programs and ensure that we are ready for the increase in ARM volume.
In determining compliance risk levels many factors must be considered; the nuances and longevity of the regulation, the complexity of the product, and more important, is the customer a business or an individual. Lending to consumers in general exposes institutions to elevated risk. Of all consumer lending, ARMs are of the highest risk because there are many more disclosure requirements and opportunities for inconsistencies where something can go wrong…and sadly oftentimes do.
Don’t assume that because there have been no issues in the past, there are no problems with origination of your ARMs. Indices, such as the 1 Year CMT, have been very low and very flat for a long time. It is only now, when the indices are changing dramatically, that we are observing errors in the origination process.
We have seen an increase in errors during our compliance reviews related to ARM loans. The errors identified are found in all applicable areas – origination, processing, closing, and servicing and many of these errors result in potential restitution. This is the first of a three-part series on the common pitfalls and best practices for keeping your ARM loan compliance on point.
Let’s start at the very beginning – Loan Origination
LOAN ORIGINATION
CHARM Booklet
The CFPB updated the CHARM Booklet. You should ensure that you are providing customers with the current CHARM Booklet dated 06/2020. Most Loan Origination Systems (LOS) provide the CHARM Booklet in the document sets for ARM loans; remember to make sure the system is going to the correct URL for the Booklet.
Origination Documents
We recommend that you review the origination documents for each type of ARM product offered to ensure all key elements are consistent. The Note is our governing document, all other documents should be consistent with the terms of the Note. We recommend that you pull:
- Note
- ARM Disclosure – Required to be updated annually or when there is a product change.
- Loan Estimate (LE)/Closing Disclosure (CD)
The documents should all provide consistent information on the following:
Index – Ensure that the index is correct on each document. Remember that the 1 Year CMT Daily is different from the 1 Year CMT Weekly Average. These are two different indices, which in the current rate environment are typically two different values. What index are you using? Is the index consistent between the Note, ARM Disclosure, Loan Estimate and Closing Disclosure?
While all components of ARM Disclosures are important, the index is one of the most critical pieces of information utilized for disclosure purposes. A current index must be utilized for disclosure purposes, and failure to disclose based on the fully indexed rate can result in an understated APR and potential restitution. The fully indexed rate is defined as the current index plus the Bank’s margin and, if stated in the Note, rounded usually to the nearest .125% (See Rounding Methodology below).
When we provide a Loan Estimate or Closing Disclosure the fully indexed rate utilized by the Loan Origination System (LOS) must be “current”. For most current Notes there is a 45 day look back period when establishing the fully indexed rate, thus a “current” index, is an index that is no more than 45 days old at the time we are issuing the Loan Estimate AND no more than 45 days old as of the date of closing when providing the Closing Disclosure. It is critical that when a Closing Disclosure is issued, the index is current. In most LOS systems this requires that the closer manually click a radio button that states “update index” within the LOS. Otherwise, the software will continue to use the initial index at the time the loan was placed in the LOS system.
Remember that the LOS cannot utilize current index data unless the current index is available in the system. This means that a staff member is responsible for placing the index data in the system. Management should verify that procedures are in place to ensure that the index is being updated each time a new index is available (i.e., daily, weekly, etc.).
Understand what is required within your LOS to ensure a current index is being utilized and make this part of your procedure when originating ARMs. If the LOS permits “warnings” to be set in the system, make sure that you program a warning or alert to update the index. In a rising interest rate environment, failure to provide a current index contributing to key calculations on the Closing Disclosure will result in an understated APR and potential restitution.
Margin – The margin that is added to the index should be consistent on all documents.
Rounding Methodology – Notes contain options for the rounding methodology when adding the index to the margin. Documents must reflect the rounding methodology contained within the Note. Common methodologies are: –
- No rounding – just the index plus the margin
- “To the nearest 0.125%”
- “Up to the nearest 0.125%”
- “Down to the nearest 0.125%”
Floor Rates – Floor rates can vary based on the program you have developed. Does your product not have a floor? Is the floor rate the margin? Is the floor rate the start rate? Review the Note and ensure that all disclosures reflect the proper floor rate for the loan. A CD that reflects the floor at the margin, and the Note states that it is floored at the start rate, will cause the APR to be inaccurate and there is the risk of potential restitution.
Rate Caps – Again, this is a field unique to the type of ARM you are offering. Understand your rate caps and make sure that the disclosures match the rate caps on the Note.
Tips to Avoid Compliance Pitfalls at Origination:
- Review all ARMs in the LOS. Don’t assume because the 5/1 ARM is correct, all other ARM product types were set up correctly.
- Test the data output from your LOS. This means doing the “math” and validating that the information on LE, CD and ARM Disclosure are correct based on the terms of the Note.
- Ensure that someone is responsible for maintaining the index in the LOS, and that there is a back-up person assigned.
- Use a dual control process, so the data entry on the index is reverified by a “second set of eyes”.
- Lock down fields in the ARM Program set-up so users cannot change your ARM Program, such as the index used, margin, rate caps or rounding methodology.
- Lock down the documents tied to the specific ARM product to ensure that processing and closing staff cannot select a different Note type or ARM Disclosure which is inconsistent with the ARM Program being originated.
- Ensure that staff are trained in using the LOS when disclosing ARMs. This includes manually updating the index when required.
- Some LOS systems permit “warnings” to be set. Set a warning for utilizing the current index.
- Review the ARM products set up in the LOS. Remove any stale or suspended loan programs.
The second article in this three-part series will focus on Regulation Z’s ATR/QM requirements as they relate to ARM Loans.
TCA is “A Better Way” to help you manage ARM Loan compliance.
