Article by Joe Hand

DEFINITIONS USED IN BANKING:

Here is some of the terms that are used in the Banking Industry.

ACCUMULATOR: A clause in loans which allows the increased index to accumulate to later adjustment periods for rate adjustments in the event an interim rate cap has kept the note rate from meeting the indicated rate of index – margin. (ie: index jumps 4 points, rate cap of one point/year, lender makes next 3 adjustments over 3 more years if index remains the same).
A.M.R.,A.M.L., V.I.R.: All terms for adjustable instruments, with the same meanings, Adjustable Rate Mortgages, Adjustable Mortgage Loans, Variable Interest Rate Loans.
ASSUMABILITY: A clause or rider to a note allowing for assumption by a third party under certain conditions. Usually, normal credit and income requirements must be met for loan assumption. Normally a fee of 1% of the loan balance is charged for formal assumption, but this can vary. Beware of loans with assumability clauses in which the lender has the right to “rate review” or change at the time of assumption.
BASIS POINTS: Margins are expressed in basis points; 100 B P’s is equal to 1%.
BUY DOWN: Either a paid for or free lowering of the interest rate at the beginning or life of the loan. In ARM’ Sit can mean a lowered initial or ‘strike rate’.
CAP: A limit to interest rate or payment, either at given intervals (called interim caps) or for the life of the loan (called life cap). Typical payment cap is 7.5% per year and usually allows for negative amortization. Interim rate capes can be from 3/8% per 6 months to 2% per year. Life caps generally range from 3 1/2% to 6% or may not exist at all.
CONVERSION OPTION: An option written into the terms of the ARM allowing the borrower the right to convert his loan to a fixed rate, at the then current fixed rate available from his lender. These options generally fall on loan anniversary or recasting dates, (ie: 1 year, 2 year etc.). DISCLOSURE, FEDERAL REG Z: An advance notice of the costs incurred in connection with an applied for loan, including the APR (Annual Percentage Rate) calculation for the life of the loan based on estimated life rate and loan fees charged. On ARM’s the lender is required to calculate this APR based on the expected rate changes to his loan based on index and margin at the time the loan will record.
EQUITY SHARING: Any loan instrument in which the lender may participate in the home owner’s equity because of terms of the loan. In ARM’s with potential negative amortization , the lender participates because his rate is increasing faster that the payments can catch up so equity to the homeowner is being eroded; the lender is getting it.
EQUITY SHOCK; In the case of equity sharing or negative amortization, this is the sudden or gradual realization by the buyer that his equity in the home is being eroded. Every month, his loan is increasing, taking away from his equity, the only saving factor is potential price appreciation to compensate. If there is none, the borrower may quit paying and leave, causing foreclosure and repossession by the lender.
GRADUATED PAYMENT: Predetermined payment increases over a certain period of the loan, usually the beginning. Graduated payments generally allow for negative amortization in the beginning years of the loan (3-7) them leveling of the payment after a certain term. Some graduated payments continue for the life of the loan, greatly shortening the term, and total cost of interest; these are referred to as GEM loans (Growth Equity Mortgages).
INDEX: The indicator by which rate changes are determined on an ARM. The index must be one out of the control of the lender. Usually T-Bill rates and Cost of Funds Indexes are used. Typical: FHLBB coast of funds, 6 months to 5 years Treasury Security rates. If the index goes up the lender may raise the interest rate (subject to interim rate caps) and if it falls, the lender must drop the rate (same cap limitations apply).
INTERIM CAP: A short-term CAP or limit to payment or rate changes. Payment caps are usually 7 1/2% per year, and may be tied to rate changes or not. They protection that regardless of radical changes in their index, the rate can move only certain increments per period (ie: 6 months, 1 year, 5 year). Interim caps may be subject to accumulators.
MARGIN DIFFERENTIAL: The amount by which the lender;s spread is calculated between the index he uses and the interest rate he may charge. A margin can be positive or negative (very rare). They are expressed in basis points; 100 B P’s = 1.0%. Example: An index of 10.5% + a margin of 250 B P’s indicates a note rate of 13.00%. NOTE: Many ARM’s have beginning interest rates which do not coincide with the sum of index and margin. (See Strike Rate)
NEGATIVE (REVERSE) AMORTIZATION: When payments are not sufficient to cover the interest charge monthly on an amortized loan, the deficiency is added to the note balance and charged interest at the current note rate. Negative amortization is the result, the loan is going up instead of down. Federal law limits the maximum negative amortization to 25% of the original loan. (ie: an $80,000 can never exceed $100,000, if it does reach $100,00, the payment cap is removed from the loan, Negative Amortization can cause equity shock.
PAYMENT SHOCK: If a loan is “deep discounted”, meaning the beginning payment and rate are substantially below the indicated rate of index + margin, then a rapid payment increase is eminent, causing payment shock. Also, loans with rapidly moving interim rate caps can cause payment shock. Payment caps of 7 1/2%can eliminate payment shock, but they only convert it to equity shock. Example: A 2% per year rate cap with no payment cap causes annual payment increases of about 16%.
POINTS: One point equals one percent. Points are charged as loan origination fees, usually 1 1/2 to 3 1/3 points charged in order to increase yield to the lender and offset origination and processing costs. Some lenders express changes in ARM loan rates as points. In yield calculations, it generally takes 1 point in origination to increase yield on the loan by 1/8%m based on a holding period of approximately 12 years.
RECASTING: (Re amortization) When a loan interest rate is changed, a payment change is required in order to assure the loan will be paid off at the end of its term (30 years). If the loan is to have no negative amortization them recasting is needed at each potential rate change, ie: 6 months, 1 year, etc. The remaining balance is applied to the new interest rate over the remaining term of the loan to calculate a new payment. Also, recasting is used on most loans with 7 1/2% payment caps to limit the amount of negative amortization possible. The loan will be subject to payment caps annually, except each 5 years, when the payment is calculated without respect to the caps, and a dramatic increase can be experienced, causing ‘payment shock’. One major advantage to recasting is the ability toi pay down a loan and have the payments substantially decreased, when the next rate anniversary occurs, an option not generally available on fixed rate loans.
STRIKE RATE: An interest rate at the beginning of the ARM which is different from the rate indicated by adding together index and margin. The strike rate is used to lure the borrower in to the front-end of the loan because the lender can take advantage of higher rate later. A typical example of strike rate is a loan with an index of 10.5% and margin of 2.5%, indicating a required note rate of 13.0%, but the first year’s rate is 11.25%. The loan look like a bargain, but will increase by 1.75% at the first allowable change if the index remains constant. (subject to interim rate caps) NOTE: Some loans also allow for a one-time “free” rate adjustment from the strike rate, usually in 6 months, without respect to interim and life caps of the loan. In other words, the life cap comes in after the first “free” rate adjustment. Be careful!
YIELD: If a note were executed at a certain rate of interest without any origination costs, or repayment penalties, then the face rate of the note would equal the yield. However, in institutional (and private) lending, origination fees, discounts, or points are charged up front as an additional income to the lender. These charges cause the yield to be greater than the face rate. The longer the note lasts, the lower the yield becomes, once the costs are incurred. In a typical note, a 2 point (or percent) loan charge will increase yield by 1/4%. Yield estimates are calculated when determining A.P.R. on federal disclosure notices.

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