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Stricter mortgage rules will allow ARMs

By Holden Lewis ·
Friday, April 1, 2011
Posted: 10 am ET

You'll be able to get an adjustable-rate mortgage at a relatively attractive rate, even after regulators impose stricter underwriting rules.

This week, the feds proposed tight underwriting standards for "qualified residential mortgages," or QRMs. I'll explain further in a later paragraph because I don't want your eyes to glaze over yet. Suffice to say that qualified residential mortgages will have lower rates and probably lower fees than mortgages that don't fall under the QRM label.

A summary of the QRM proposal, leaked Monday night, said that loans with the potential of "significant interest rate increases" would not fall under the QRM definition. The full proposal is more specific, and it gives the green light to hybrid ARMs such as the 3/1 or 5/1 adjustable-rate mortgages.

To meet the QRM guidelines, an ARM couldn't rise in rate more than 2 percentage points in any one year, and it couldn't rise more than 6 percentage points over the life of the loan. This would require a change in what are called "initial caps." The initial cap limits how much the rate can rise upon the first adjustment.

Right now, 3/1 ARMs typically can rise either 2 or 3 percentage points on the first adjustment, depending on the loan. On 5/1 and 7/1 ARMs, the first adjustment typically can rise up to 5 percentage points.

Under the QRM requirement, the initial cap for all of those ARMs would have to be 2 percentage points. This lower initial cap will have a couple of effects.

First, introductory rates probably will be a little higher that they otherwise would be.

Second, borrowers will switch to shorter-term ARMs. Tomorrow's 3/1 ARM will carry about the same risk to the borrower as today's 5/1 ARM. If you think you'll sell your home within five years, you'll probably choose the 3/1 ARM instead of the 5/1 ARM, because if you have the loan for five years, the first two adjustments won't kill you.

And I guess that carries a third implication: With the initial cap limited to 2 percentage points, more borrowers will choose ARMs. I suspect that ARMs will grab quite a bit of market share.

Banks will be able to offer non-QRM home loans, too. QRM loans have advantages for lenders. Banks will be able to sell QRMs freely. When they underwrite mortgages that don't fall under the definition of QRMs, banks will have to keep 5 percent of the risk. When loans go bust, the banks will take the first 5 percent of losses before investors lose.

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Barak Volner
April 03, 2011 at 2:25 pm

It's a start to recovery.