ARM loan FAQs & servicing tips

NOTE: Click each of the following hyperlinks to jump to that section instead of having to scroll: Borrower Notices, Interest Rate/Payment Change at Same Time, Negative Amortization, Payment Shortages, Payment Overages, Correction of Adjustment Errors, Nature of Adjustment Errors, or Notifying Borrowers About Corrections.

CAUTION: Applied Business Software makes every reasonable effort to present complete, accurate information, but assumes no liability for errors or omissions.

Borrower Notices:

The servicer of an adjustable-rate or graduated-payment adjustable-rate mortgage must notify the borrower before the effective date of any change in the mortgage interest rate or the monthly payment. When the two change at different times, a notice is required before each of the changes. The notice of a payment change should always be mailed in time to reach the borrower at least 25 days before the new monthly payment becomes effective. All notices must include the name, title, and the telephone number of a person who will be able to answer any inquiries the borrower may have about the notice. Other information will vary slightly for some of the plans, to recognize differences related to negative amortization, options for limited payment amounts, extensions of graduated-payment periods, or conversion to fixed-rate mortgage options.

Interest Rate/Payment Change at Same Time:

Only one notice is required when the interest rate and payment changes occur at the same time. The content of the notice will vary depending on whether the mortgage will fully amortize at the new interest rate, whether the borrower has an option to choose a limited payment amount.

Negative Amortization:

When an adjustable-rate or graduated-payment mortgage is undergoing negative amortization, the monthly fixed installment cannot be allocated between principal and interest. In fact, the fixed installment will not cover all of the accrued interest. When this interest shortfall occurs, the unpaid principal balance of the mortgage should be increased by the amount of the shortfall.

Payment Shortages:

Sometimes payments received from the borrower are less than the total amount due. The servicer should not automatically return these payments to the borrower. Instead, the servicer should base its decision to process partial payments on the amount of the shortage and on any special circumstances that might justify the lesser amount. If the servicer decides to accept the payment, any portion of it that equals one or more full installments should be applied. Any remaining portion should be held as "unapplied funds" until enough money to make a full installment is received.

Payment Overages:

Sometimes payments received from the borrower are more than the total amount due. If the borrower does not explain the extra amount, the servicer should base its procedures for processing these payments on the amount of the overage. The servicer may establish either a specific dollar amount or a percentage of the mortgage payment as a guideline for determining how these payments should be handled. Amounts under these guidelines can be deposited to the borrower's escrow account if the servicer is maintaining one; otherwise, they should be held as "unapplied funds" until the servicer is able to determine their proper disposition. Amounts exceeding these guidelines should be held as "unapplied funds" until the servicer determines why the larger payment was submitted.

Correction of Adjustment Errors:

The best way of avoiding ARM adjustment errors is to have in place loan servicing procedures to assure that the characteristics of an adjustable-rate mortgage are properly followed and implemented. However, even with the appropriate procedures and systems in place, adjustment errors may still occur.

Discovery of an ARM adjustment error may be the result of the servicer's internal audit of its ARM adjustments, an audit by the servicer's regulator, a due diligence review by a potential transferee servicer, or an inquiry from the borrower. Once ARM adjustment errors are identified, the servicer must take prompt action (within 60 days) to correct them and to notify the borrower about the effect of the correction. All actions taken to correct an ARM adjustment error must be made in accordance with federal law (including the Truth-in-Lending Act and its implementing regulations), state law, and the terms of the relevant mortgage instruments.

A servicer should also consult with its tax advisors regarding the effect that the correction of an ARM adjustment error may have and the information it may be required to report to a borrower or to the Internal Revenue Service (IRS) about the amount of interest paid by a borrower. Treasury regulations (26 CFR, Section 1.6050H-2), which were promulgated under Section 6050H of the Internal Revenue Code, require that certain reimbursements of interest overcharges be reported to the IRS on the Mortgage Interest Statement (IRS Form 1098) and that a copy of this form (or a substitute information statement) be furnished to the borrower.

Nature of Adjustment Errors:

Most ARM adjustment errors will involve an incorrect calculation of both the interest rate and the monthly payment; others may involve an incorrect calculation of the monthly payment only, an incorrect calculation of the interest rate only, or a failure to provide timely notification of the borrower's option to convert to a fixed-rate mortgage. Some errors will result only in the mortgage amortizing incorrectly, while others will result in the borrower's monthly payment having been higher or lower than it should have been.

Incorrect interest rate and monthly payment. Most of the adjustable-rate mortgages have corresponding interest rate and payment adjustment periods. This means that the monthly payment is changed exactly one month following the interest rate change date, based on the new interest rate that goes into effect on the interest rate change date. Therefore, if the servicer incorrectly calculates the interest rate on an interest rate change date, the monthly payment generally will also be incorrect since it will be based on the erroneous interest rate.

Adjustment errors that result in both an incorrect interest rate and monthly payment may be caused by a simple mathematical error or by use of the wrong index, use of an incorrect mortgage margin, use of an incorrect index value, use of an interest rate and/or payment cap when the mortgage instrument did not provide for caps, use of an incorrect interest rate and/or payment cap, or failure to apply an interest rate and/or payment cap specified in the mortgage instrument.

Incorrect monthly payment only. Some adjustable-rate mortgages have graduated-payment periods, which means that the monthly payment can change more frequently than the mortgage interest rate. Therefore, it is possible for the servicer to calculate a monthly payment incorrectly without affecting the mortgage interest rate—as long as the error is discovered before an interest rate change occurs. In such cases, the payments will have been incorrectly applied between principal and interest. This type of error will be compounded if it is not discovered until after an interest rate change occurs since the new monthly payment calculated on the interest rate change date could have been based on an incorrect unpaid principal balance.

An ARM adjustment error that results in an incorrect monthly payment may be caused by a simple mathematical error or by use of a payment cap when the mortgage documents did not provide for a cap, use of an incorrect payment cap, or failure to apply a payment cap specified in the mortgage documents.

Incorrect interest rate only. Some adjustable-rate mortgages call for the interest rate to change more frequently than the monthly payment, which may result in negative amortization. A servicer's adjustment error for one of these mortgages can affect the mortgage interest rate only—if the error is discovered before a payment change occurs. In such cases, the borrower will not have made incorrect payments, rather the payments will have been incorrectly allocated between interest and principal. However, if the error is not discovered until after a payment change occurs, the amount of the borrower's payment would have been too high or too low (because the new payment would have been based on an incorrect unpaid balance and, possibly, on an incorrect interest rate).

Adjustment errors that result in an incorrect interest rate may be caused by a simply mathematical error or by use of the wrong index, use of an incorrect mortgage margin, use of an incorrect index value, use of an interest rate cap when the mortgage instrument did not provide for one, use of an incorrect interest rate cap, or failure to apply an interest rate cap specified in the mortgage instrument.

Notifying Borrowers About Corrections:

Under Regulation Z (12 CFR 226), a lender must make certain disclosures to borrowers who have adjustable-rate mortgages before the due date of any payment that is based on a new interest rate. The disclosures include the current and previous interest rates, the index values on which the current and previous interest rates were based, the new monthly payment amount, and the unpaid principal balance of the mortgage. Thus, when a servicer miscalculates an ARM adjustment and discloses an erroneous interest rate, payment amount, or mortgage balance, it is in violation of Section 226.20(c) of Regulation Z. Since this violation will affect future disclosures, the servicer must either make a dollar adjustment with the borrower or to the borrower's account to assure that future disclosures will accurately reflect the borrower's legal obligation for the mortgage. To make sure that it is in full compliance with the record-keeping requirements of Regulation Z, a servicer should also maintain for a period of at least two years a record of all adjustments that it makes to any adjustable-rate mortgage and documentation reflecting any corrective actions that it has taken.

The servicer must give the borrower at least 25 days' advance notice of any payment change that results from the correction of an adjustment error. For example: If the servicer makes an interest rate adjustment correction on April 10 for a mortgage that had an April 1 LPI date and sends the borrower notice of the change on this same day, the corrected payment cannot go into effect until the June payment (in order to give the borrower the full 25 days' advance notice of the payment change). This means that the May payment must be applied at the incorrect interest rate and/or payment amount, even though the borrower cannot be billed for an undercharge for the additional month and the servicer will need to make a subsequent adjustment to correct an overcharge for the additional month.

The servicer's notification to the borrower must advise him or her about the correct interest rate and/or monthly payment, the effective date for any change in the interest rate and/or monthly payment, and the amount of any overcharge that will be available for refunding or crediting to the borrower's account. The servicer's notification should include either a check for the amount of the overcharge or an explanation of how the overcharge will be credited to the borrower's account. The notification should also include a discussion of the borrower's option to return all or a portion of any cash refund to the servicer for application to the unpaid principal balance of the mortgage.

The servicer's notification should also advise the borrower about whether the amount of any refund (or credit) resulting from an interest overcharge will be reflected in the Mortgage Interest Statement (IRS Form 1098) that the servicer submits to the IRS to report the amount of interest that the borrower paid during the year that the refund (or credit) is being made and should suggest that the borrower may want to consult a tax advisor. Treasury regulations also require that the borrower's copy of the Mortgage Interest Statement (IRS Form 1098) or any equivalent information return that the servicer uses include instructions that (1) the amount of the refund of an interest overcharge is not to be counted as an "itemized deduction" and (2) the amount of the refund (or credit) for the interest overcharge must be included in the borrower's gross income for the current tax year if the borrower deducted the reimbursed interest in a previous year in order to reduce his or her tax liability.

The servicer's notification should fully explain why no cash refund is being made in any instance in which the borrower is not due a cash refund for an overcharge (as would be the case for the correction of an incorrect interest rate only or as could be the case for the correction of an incorrect payment change only) and, if the error related to a payment change only, discuss any options that are available to the borrower. If the error related to an interest rate change only, the notification should also mention whether the servicer will reflect the amount of the credit resulting from the correction of the interest overcharge that is applied to reduce the unpaid principal balance of the mortgage in the Mortgage Interest Statement (IRS Form 1098) that it submits to the IRS for the year in which the refund (or credit) is being made and suggest that the borrower may want to consult a tax advisor.