Part 2 of a 3 Part Series
In our last article, TCA recapped items necessary for origination and proper disclosure of ARM Loans. In this second article, we will review the requirements for complying with underwriting requirements unique to Adjustable-Rate Mortgages.
Underwriting ARM Loans
While banks are required to comply with the Ability-to-Repay standards in Regulation Z, the Bank is not required to comply with the Qualified Mortgage (QM) rules. If the Bank or the Banks’ investors require compliance with QM due to the protections available, you must remember the QM rules have been updated as of October 1, 2022 to a price-based QM. Under the requirements of the new price-based QM rules 1/1 ARMs and 3/1 ARMS will oftentimes not qualify as a QM.
Let’s dive a little deeper into ATR and QM
Ability-To-Repay
Under the Ability-to-Repay rules, the borrower must qualify based on the higher of the start rate or fully indexed rate. If the start rate is 4.00% and the fully indexed rate is 4.75%, you must document in the loan file that the borrower qualified at a minimum of 4.75%. If the start rate is 5.25% and the fully indexed rate is 4.50%, you must document that the borrower qualifies at 5.25% at a minimum. The Bank’s internal policy may require qualification at a higher rate.
Qualified Mortages
If the Bank or Bank’s Investor requires the loan to be a Qualified Mortgage, there are additional considerations in both the qualification and pricing of an ARM loan under the QM rules. This article does not outline all of the QM requirements but focuses on the calculations for qualification and pricing that are unique to ARMs. For details on all QM requirements refer to §1026.43(e).
Qualified Mortgage – Borrower Qualification
To comply with QM, the Bank must document the borrower qualifies at the maximum interest rate that may apply during the first five years after the date on which the first regular periodic payment will be due, i.e., the rate in Month 61.
As an example:
Loan Terms:
- 3/1 ARM
- 4.00% start rate
- Periodic rate cap of 2%/Lifetime Rate Cap 6% over start rate (10%)
- Years 1-3 – 4.00% (Payments 1-36)
- Year 4 – 6.00% (Payments 37-48)
- Year 5 – 8.00% (Payments 49-60)
- Year 6 – 10.00% (Payment 61)
The Bank would be required to document in the file the borrower qualifies at a rate of 10.00%.
Qualified Mortgage – Price Testing
In order to be considered a Qualified Mortgage, the loan must pass a price-based test. To determine whether a loan passes this price-based test, the Bank must compare the loan’s Annual Percentage Rate (APR) against the Average Price Offer Rate (APOR) by entering information into the CFPB’s Rate Spread Calculator. The chart below outlines pricing requirements as of 2023:
There are special calculations the Bank must perform when testing the APR for an ARM Loan for QM Price Testing purposes.
An ARM loan which has a rate change in the first five years after the date of the first payment, requires that the creditor to determine the APR treating the maximum interest rate that may apply during that five-year period as the interest rate for the full term of the loan. The Bank will utilize this calculated APR to compare to the APOR to determine if the APR threshold has been met.
Those are a lot of regulatory words, so let’s simplify–Take the highest rate possible at month 61 and calculate the APR based on that rate over the entire term of the loan. When calculating the APR, you must include the Prepaid Interest Charges at the highest possible rate at month 61.
If you are hitting panic mode (math does that to people) – Stop, take a deep breath, and know that most LOS systems have a built-in component to test for QM. However, it is never a bad idea to understand and validate (remember “Trust but Verify”) the methodology behind the scenes.
This is best demonstrated by an example:
Loan Terms
| Loan | $100,000 |
| Product | Product |
| Start rate | 3.75% start rate with 2/6 Caps |
| Prepaid Interest | 15 days |
| Prepaid Finance Charge | $0 |
Rate Analysis
| Years 1-3 (Payments 1-36) | 3.75% |
| Year 4 (payments 37-48) | 5.75% |
| Year 5 (Payment 49-60) | 7.75% |
| Year 6 (Payment 61)* | 9.75% |
APR Calculation to compare to APOR
| Prepaid Interest | $400.68 (Based on 9.75%*) |
| Amount Financed: | $99,599.32 |
| Finance Charge: | $209,694.68 |
| Payments: | 360 @ $859.15 (Based on 9.75%*) |
| Resulting APR: | 9.797% |
The APR of 9.797% will be used for QM testing. The resulting APR will be entered into the CFPB’s Rate Spread Calculator to determine the rate spread between the APR and APOR based on the rate lock date. The result will be compared to the above chart to determine if the loan passes the Qualified Mortgage Price Testing component.
Tips To Avoid Errors in ATR or QM
- While your underwriting standards or your investors’ underwriting standards may be different, ensure that you have documented on the 1008 or Loan Approval form that the borrower qualified at the required rate for ATR and if applicable, QM.
- If you require originations of a QM loan, test the rates on your 1/1 ARMs, 3/1 ARMs, and 5/1 ARMs to ensure that they will retain QM status. Due to the calculations required under QM many of the ARMs in which the rate changes in five years or less may not qualify for QM.
- Remember the APR calculation provided above will be utilized for QM testing only. It is NOT the APR for the loan, nor the APR disclosed on the Closing Disclosure.
- The Price Testing component of QM is updated annually. The Chart provided above are values for 2023 only. Updates will be provided by the CFPB usually in the 4th Quarter.
TCA is “A Better Way” to help you manage ARM Loan compliance.
