March 19, 2004

> **MORTGAGEE LETTER 2004-10**

##### TO: ALL APPROVED MORTGAGEES

**SUBJECT: Adjustable Rate Mortgages**

On March 10, 2004, the Department of Housing and Urban Development
published a final rule in the *Federal Register* amending the mortgage
insurance regulations to implement additional product offerings known as
"hybrid" adjustable rate mortgages (ARMs). The Federal Housing
Administration (FHA) has insured ARMs since 1984; however, these were
limited to 1-year ARMs. Under the terms and conditions described below,
FHA is now offering mortgage insurance on 3-year, 5-year, 7-year and
10-year ARMs. These hybrid ARMs expand home buying opportunities through
the creation of additional product offerings tailored to the financial
conditions and desires of the borrowers.

This Mortgagee Letter provides a synopsis of the final rule, as well as
specific guidance to assist lenders with implementing these new
products. It supercedes Mortgagee Letter 89-24, FHA's prior instructions
on 1-year ARMs, and incorporates the two paragraphs from Mortgagee
Letter

98-1 which apply to ARMs. This Mortgagee Letter contains a definition
section at the end.

# [Highlights of the Final Rule]{.underline}

In addition to 1-year ARMs, under this rule change, FHA may insure ARMs
on single-family properties that have interest rates that are fixed for
the first three years, five years, seven years or ten years of the
mortgage term and adjusted annually thereafter. The 1-, 3- and 5-year
ARMs allow a one percentage point annual interest rate adjustment after
the initial fixed interest rate period and a five percentage point
interest rate cap over the life of the loan. The 7- and 10-year ARMs
allow a two percentage point annual interest rate adjustment after the
initial fixed interest rate period and a six percentage point interest
rate cap over the life of the loan.

The final rule also requires a pre-loan disclosure. A mortgagee must
provide the mortgagor, at the time of loan application, a written
explanation of the features of the adjustable rate mortgage consistent
with requirements applicable to variable rate mortgages secured by a
principal dwelling under the Truth-In-Lending Act (TILA), "Regulation
Z," at 15 USC 1601, 12 CFR §226.18. FHA will not provide these
disclosures.

2

# 

# [Programs Eligible for Hybrid ARMs]{.underline}

These products may be used on owner-occupied principal residences only
for loans to be insured under sections 203(b)(single-family mortgage
insurance), 203(h)(disaster victims), 203(k)(rehabilitation loans) and
234(c)(mortgage insurance on condominium units). Lenders are not
permitted to make ARMs to nonprofits (including those normally eligible
as mortgagors) and units of government.

# [Frequency of Interest Rate Changes]{.underline}

Interest rate adjustments must occur on an annual basis, except that the
first adjustment may occur no sooner than:

1-year ARMs - no sooner than 12 months nor later than 18 months

3-year ARMs -- no sooner than 36 months nor later than 42 months

5-year ARMs -- no sooner than 60 months nor later than 66 months

7-year ARMs -- no sooner than 84 months nor later than 90 months

> 10-year ARMs -- no sooner than 120 months nor later than 126 months

# [Pre-loan Disclosure]{.underline}

Mortgagees must make available to the mortgagor, at the time of loan
application, a written explanation of the features of an ARM consistent
with the disclosure requirements applicable to

variable rate mortgages secured by a principal dwelling under TILA.
Since mortgage lenders already prepare their own disclosures for FHA
1-year ARMs as well as conventional ARMs, FHA will rely upon lenders to
comply with TILA and will not provide disclosures for these products. On
the date of the loan application, the lender must explain fully and in
writing to the prospective mortgagor, the nature of the proposed
obligation.

A hypothetical monthly payment schedule that displays the maximum
potential increases in monthly payments for the term of the ARM must be
provided to the applicant. For example, a 7-year ARM payment schedule
would show the maximum potential increases over the three years
following the initial fixed interest rate period of 7 years.

> Note: Examples will differ depending on the caps, i.e., 1/5 vs. 2/6.
> The hypothetical payment schedule will illustrate the maximum
> increases over the shortest possible time frame.

# [Underwriting]{.underline}

The ARM loan will be processed and underwritten using the initial
interest rate negotiated between the lender and borrower, as stated in
the Form HUD-92900-A, Addendum to Uniform Residential Loan Application.
Mortgage credit processing shall be in accordance with existing
instructions except as modified below:

3

> a\. An adjustable rate mortgage disclosure statement, signed by all
> borrowers, must accompany the loan application and applicable FHA
> addenda. The disclosure statement must meet the criteria of the
> Federal Reserve Board\'s Truth-in-Lending regulations (\"Regulation
> Z\").
>
> b\. The periodic mortgage insurance premium (MIP) amount and any
> termination provisions will be based on the initial interest rate
> throughout the term of the loan and regardless of the annual interest
> rate adjustments to the loan.
>
> c\. The initial interest rate, the margin, the date of the first
> adjustment to the interest rate and the frequency of adjustments must
> be specified in the mortgage documents.
>
> d\. For all adjustable rate mortgages, regardless of LTV, any form of
> temporary interest rate buydown is prohibited. If there is a permanent
> buydown, the underwriting will be based on the rate in the
> application.

e\. ARM loan maturities shall not exceed 30 years.

f\. This Mortgagee Letter does not apply to Home Equity Conversion
Mortgages.

> g\. Borrowers choosing the 1-year ARM must qualify for payments based
> on the contract or initial rate plus one percentage point (1%). This
> only applies to the 1-year ARM where the loan to value (LTV) is 95.00
> percent or greater. (For this purpose, the LTV is defined as the
> lesser of the base loan amount divided by the appraiser\'s estimate of
> value, or the percentage shown on line 16a of the HUD-92900-PUR or
> line 14a of the HUD-92900-WS.)

h.  Borrowers choosing the 3-, 5-, 7- or 10-year ARMs are to be
    qualified at the entry

> level (note) rate (i.e., there is no requirement to underwrite at one
> percentage point above the note rate as there is for 1-year ARMs).

# [Adjustable Rate Mortgage and Note]{.underline}

For the model adjustable rate mortgage and note, see Handbook 4165.1,
Rev 1, Chg 3, Chapter IV and the applicable appendices.

Mortgage lenders are to modify the model adjustable rate note form
contained in Handbook 4165.1, to accommodate the type of ARM being
offered (i.e., the Change Date, the limits on the interest rate changes
associated with the initial fixed rate period of the ARM and the
lifetime caps).

# [Amortization Provisions]{.underline}

The ARM must be fully-amortizing and contain amortization provisions
that allow for periodic adjustments in the rate of interest charged.

4

# [Maximum Number of ARM Units]{.underline}

The aggregate number of all ARMs insured by FHA in any fiscal year may
not exceed 30 percent of the aggregate number of mortgages insured by
the Commissioner under Title II of the National Housing Act during the
preceding fiscal year. FHA will notify lenders accordingly should it be
close to reaching that maximum percentage during any fiscal year.

# [Interest Rate Index]{.underline}

Changes in the interest rate charged on an ARM must correspond to
changes in the weekly average yield on United States Treasury securities
adjusted to a constant maturity of one year, or equivalent, as provided
by the Department of the Treasury and found on the Federal Reserve
Statistical Release H.15, Selected Interest Rates website at:
[www.federalreserve.gov/releases](http://www.federalreserve.gov/releases).
Except as otherwise provided in this Mortgagee Letter, each change in
the mortgage interest rate must correspond to the upward or downward
change in this index.

To establish the adjusted interest rate, the lender must compare the
initial contract interest rate to the sum of the current index figure
and the mortgage margin (calculated interest rate). The adjusted
interest rate will be the interest rate charged to the mortgagor,
subject to the limitations of the annual and lifetime caps for the
respective ARM type. The current index figure shall be the most recent
index figure available 30 calendar days before the Change Date
(effective date of an adjustment to the interest rate as shown in
paragraph 5(A) of the model adjusted rate note form.)

Section 203.49 (c) of the regulations has long provided for a method for
setting the new interest rate as an alternative to the use of the margin
to set the new rate. Section 203.49 (c) states that "(T)o set the new
interest rate, the mortgagee [will determine the change between the
initial (i.e., base) index figure and the current index
figure,]{.underline} or will add a specified margin to the current index
figure." However, Ginnie Mae will only purchase ARMs that use the margin
method for arriving at the new interest rate. If a lender wishes to use
the other method in the regulations for computing the new interest rate,
HUD requests that the lender contact the FHA Single Family Program
Development Office at 202-708-2121 for further guidance.

**[Method of Calculating Interest Rate Adjustments]{.underline}**

The mortgagee and the borrower negotiate the initial interest rate and
margin. The margin must be constant for the entire term of the mortgage.
To calculate the annual adjustments to the initial interest rate:

> A. Determine the current index. \"Current Index\" means the most
> recent Index figure available 30 days before the Change Date.
>
> The index used, based on the weekly average yield on United States
> Treasury securities adjusted to a constant maturity of one year, must
> be the one effective on the date thirty (30) calendar days before the
> Change Date. The Federal Reserve Board Statistical Release H.15
>
> 5
>
> is published weekly on Monday, or, on Tuesday, if Monday is a Federal
> holiday. The index figure shown on that release is effective the day
> it is issued until such time a new H.15 index is published.
>
> The following are examples of the proper index figure to use when the
> 30th calendar day falls on:

1.  A Monday that is a business day. Use the index figure contained in
    the H.15 release issued that Monday, if the 30^th^ calendar day
    prior to a Change Date and the issue date of an H.15 release both
    occur on the same day, i.e., they both occur on a Monday.

2.  A Monday that is a Federal holiday. Use the index figure in the H.15
    release issued the prior week if the 30^th^ calendar day before the
    Change Date falls on a Monday that is a Federal holiday.

3.  A day of the week other than Monday. Use the index figure in the
    H.15 release issued on the Monday of that week (or issued on Tuesday
    if that Monday is a Federal holiday).

> For example, assume a December 1, 2003 Change Date. Thirty (30)
> calendar days before December 1 is Saturday, November 1. The correct
> index figure to use is the one contained in the H.15 release issued on
> Monday of that week, which is October 27.

B. Determine the calculated interest rate. This is the current index
plus the margin (the number of basis points identified as \"margin\" in
paragraph 5(C) of the model adjustable rate note) rounded to the nearest
1/8th of one percentage point (0.125 percent). This will comply with
Ginnie Mae\'s requirement that the mortgages placed into Ginnie Mae
pools must be rounded to the nearest 1/8th of one percentage point at
each Change Date.

C.  Compare the calculated interest rate (index plus margin, rounded to
    the nearest 1/8th of one percentage point) to the existing interest
    rate (rate in effect for the preceding 12 months) to determine the
    new adjusted interest rate. If the calculated interest rate is:

    1.  Equal to the existing interest rate, the adjusted interest rate
        will be the same as the existing interest rate.

    2.  Less than the existing interest rate:

> 6
>
> a\. For 1-, 3-, and 5-year ARMs, if the calculated interest rate is
> less than one percentage point (100 basis points) higher or lower than
> the existing interest rate, the calculated interest rate will become
> the new adjusted interest rate.
>
> b\. For 7- and 10-year ARMs, if the calculated interest rate is less
> than two percentage points (200 basis points) higher or lower than the
> existing interest rate, the calculated interest rate will become the
> new adjusted interest rate.

3.  More than the existing interest rate:

> a\. For 1-, 3-, and 5-year ARMs, if the new calculated interest rate
> is more than one percentage point (100 basis points) higher or lower
> than the existing interest rate, the adjusted interest rate will be
> limited to one percentage point higher or lower than the existing
> interest rate. Index changes in excess of one percentage point (100
> basis points) may not be carried over for inclusion in an adjustment
> in a subsequent year.
>
> b\. For 7- and 10-year ARMs, if the calculated interest rate is more
> than two percentage points (200 basis points) higher or lower than the
> existing interest rate, the calculated interest rate will become the
> adjusted interest rate. Index changes in excess of two percentage
> points (200 basis points) may not be carried over for inclusion in a
> subsequent year.
>
> Adjustments in the interest rate over the entire term of the mortgage
> may not result in a change in either direction of more than five
> percentage points (500 basis points) from the initial contract
> interest rate for 1-, 3-, and 5-year ARMs or six percentage points
> (600 basis points) for 7- and 10-year ARMs.
>
> D. An adjusted interest rate becomes effective on the Change and
> thereafter will be deemed to be the existing interest rate. The new
> interest rate will remain in effect until the next Change Date. During
> the term of the mortgage, each adjustment will be effective on the
> same date of each succeeding year.

# [Method of Rate Changes]{.underline}

Interest rate changes may only be implemented through adjustments to the
mortgagor's monthly payments.

**[Computation of the Monthly Installment]{.underline}**

If there is a new interest rate on the mortgage as a result of the above
calculations, a new monthly payment must be determined. The monthly
payment attributable to principal and interest will be calculated by
determining the amount that is necessary to fully amortize the unpaid
principal balance during the remaining term of the mortgage. For this
purpose, the unpaid principal balance

7

shall mean that which would be due on the Change Date if there had been
no default in any payment, but reduced by the amount of any prepayments
to principal. (Accordingly, the mortgagee must credit all eligible
prepayments, but must not debit any delinquency.) Escrow requirements
will then be added to principal and interest to arrive at the new
monthly payment.

Since interest is payable on the first day of the month following the
month in which it accrued, the borrower will begin to pay the new
monthly payment 30 days after the Change Date, provided the borrower is
given proper notice as required under the Annual Disclosure section of
this Mortgagee Letter.

All ARM adjustments affect interest percentages only; negative
amortization is not permitted.

# [Annual Adjustment Notice]{.underline}

At least 25 days before any adjustment to a mortgagor's monthly payment
may occur, the mortgagee must advise the mortgagor of the new mortgage
interest rate, the amount of the new monthly payment, the current index,
and how the payment adjustment was calculated.

There are two basic steps which the mortgagee must take each year with
respect to the interest rate adjustment:

> Step 1: Make the computation to adjust the interest rate and the
> monthly payments. The first adjustment to the interest rate will
> become effective on the day specified in paragraph 5A of the ARM Note
> (Change Date) and thereafter each adjustment will be effective on the
> same date of each succeeding year during the term of the mortgage. (As
> previously noted, the new monthly payment is effective 30 days after
> the Change Date.)
>
> Step 2: At least 25 days before any adjustment to a mortgagor's
> monthly payment may occur, the mortgagee must advise the mortgagor of
> the new mortgage interest rate, the amount of the new monthly payment,
> the current index, and how the payment adjustment was calculated.

The mortgagee\'s obligation to compute, adjust the interest rate, if
necessary, and give notice to the mortgagor on the prescribed dates, is
not affected by delinquencies or foreclosures so long as the mortgage
debt exists. It is the mortgagee\'s responsibility to see that its
collection actions continually update the mortgage debt. Notice of any
adjustment to the interest rate and monthly payment, increase or
decrease, must be mailed to the mortgagor at least 25 days prior to the
change in payment. (If an existing mortgage provides for 30 days notice,
that provision must be followed.) Our rule concerning the timing of the
annual notice of adjustment is consistent with Federal Home Loan Bank
Board (FHLBB) regulations and policy.

8

The Adjustment Notice must contain (a) the date the Adjustment Notice is
mailed, (b) the Change Date, (c) the existing interest rate, (d) the
adjusted interest rate, (e) the current Index and publishing date, (f)
the method of calculating the adjustment to the monthly payments, (g)
the amount of the adjusted monthly payments, and (h) any other
information which may be required by law from time to time. The Notice
should contain other relevant information such as an explanation of why
the adjusted interest rate is less than the calculated interest rate
when the cap is reached.

The content of the Adjustment Notice must meet the criteria of 24 CFR
203.49(h).

It is recommended that the Notice be sent to the mortgagor by Certified
Mail, Return Receipt Requested. However, a Notice addressed and mailed
via first class mail to all property owners identified on the
mortgagee\'s records shall be sufficient unless the mortgagors\'
whereabouts are known to be elsewhere. A Notice must be given each year,
even if the existing interest rate does not change.

For HUD review purposes, lenders must keep evidence that timely notice
has been given, and evidence of the annual adjustment computations
retained for the mortgage term. A file copy of the suggested HUD annual
adjustment notice will be sufficient to satisfy this requirement.
However, should disputes arise as to timely notice or as to the annual
adjustment computations, compliance with our suggested methods may not
satisfy local legal interpretations of the mortgage provisions in
determining whether the evidence was sufficient. Lenders should,
therefore, be guided by the advice of counsel in matters concerning the
type and duration of record retention.

The mortgagee\'s collection personnel should be alerted to the prospect
of Notice not being received by the mortgagor, and should take
appropriate remedial action when necessary. If the mortgagor\'s payments
do not reflect the increase or decrease recited in the Notice, a
follow-up call should be made to determine if the Notice was received.
If it is determined that the Notice was not received, a duplicate should
be mailed promptly.

# [Failure to Provide Timely Notice]{.underline}

If the mortgagee fails to provide notice for more than one year, an
Adjusted Interest Rate must be determined for each omitted year because
the calculations for each year affect the rate for subsequent years. The
one and two percentage point limitations, and five and six percentage
point caps are applicable each year and must be taken into consideration
in determining the new Interest Rate. The mortgagee\'s failure to
provide Notice in advance of each Change Date results in penalties (to
be found in the Note) to the mortgagee.

Although the new interest rate may increase, the mortgagee is prevented
from collecting any increase in payments until such time the Notice has
met the required 25 days advance notice requirement. If timely notice is
not provided, the lender forfeits its right to collect the increased
amount and the borrower is relieved from the obligation to pay the
increased payment amount.

9

In the event that the new interest rate was to decline, the failure of
the mortgagee to provide proper Notice would result in overpayments
until the mortgage rate was properly adjusted. In such case, the
mortgagee must refund the excess with interest, at a rate equal to the
sum of the Margin and the Index in effect on the Change Date, from the
date of the excess payment to the date of repayment. The borrower has
the option of a cash refund or application of the excess to the unpaid
principal balance of the mortgage, after application of the refund to
any existing delinquency.

**[Failure to Provide Accurate Notice]{.underline}**

If the mortgagee miscalculates the interest rate and/or the monthly
payment, and the error(s) are reflected in the Notice, HUD takes the
position that the errors need to be corrected. However, HUD takes no
position as to whether an erroneous Notice would constitute a failure to
provide notice under the terms of the mortgage contract. This is a legal
matter subject to local law and court interpretation.

# [Sales, Assignments and Transfers of Servicing Among Mortgagees]{.underline}

It is the responsibility of the transferor (seller) to provide the
transferee with complete servicing records reflecting total compliance
with ARM disclosure and reporting requirements. Although HUD regulations
require the transferee/assignee to assume all servicing obligations, we
do not intend that a negligent ARM mortgagee-transferor be permitted to
avoid its disclosure obligations. In the event that a failure of Notice
or other error is discovered, it shall be the responsibility of the
mortgagee-transferor who was holding the loan when the failure occurred,
to reimburse the mortgagee currently holding the loan, where any burden
of refund to the mortgagor is required.

# [Assumptions]{.underline}

Lenders should encourage sellers to disclose the terms of an existing
ARM in any sales transaction; however, when an assumption takes place
both the seller and the lender should assume responsibility for
notifying the purchaser (assumptor) about the terms and conditions of
the ARM.

As soon as the lender becomes aware of an assumption and has the name of
the purchaser, it should provide the purchaser with a copy of the
original Disclosure Statement and an explanatory letter addressing the
ARM obligations. Documented acknowledgement of the assumptor's receipt
of this information is advisable.

For assumption transactions which require a creditworthiness review or
in cases where a release from personal liability is requested and
approved, the lender must prepare a new Disclosure

Statement to ensure that the purchaser is aware of the ARM obligation.
Processing of the HUD-92210, Request for Credit Approval of Substitute
Mortgagor, and/or HUD-92210.1, Approval of Purchaser and Release of
Seller or other similar forms used by the lender, must be based on the
interest rate in effect at the time the complete credit review package
is submitted to the DE Underwriter.

10

##### [Statistical Information]{.underline}

To track ARM activity, the following case number suffix codes (Section
of the Act ADP Codes) will be indicated on all HUD application addendums
(Form HUD-92900) and printed on computer generated mortgage insurance
certificates (Form 59100). The suffix codes for DE cases are as follows:

  ----------------------------------- -----------------------------------
  Eligible Program                    Section of the Act Suffix Code --
                                      Direct Endorsement

  203(b)                              729

  223(e)                              829

  203(k) first lien                   730

  234(c)                              731

  247 - Hawaiian Homelands            780

  248 - Indian Lands                  788

  203(k)- Condominium                 815
  ----------------------------------- -----------------------------------

[]{.mark}

# [Product Identifier]{.underline}

In addition to existing Automated Data Processing (ADP) codes assigned
to ARMs, a hybrid ARM-type indicator has been added to FHA's
Computerized Home Underwriting Management System (CHUMS). When
submitting loan data to FHA via the FHA Connection or its functional
equivalent, if an ARM is indicated by an ADP code, the lender must also
identify the type of ARM by selecting the 1-, 3-, 5-, 7- or 10-year
ARM-type indicator. This process is less likely to result in errors than
adding additional ADP codes for each individual hybrid ARM offering.

[]{.mark}

###### Definitions

[]{.mark}

INDEX The weekly average yield on United States Treasury securities
adjusted to a constant maturity of one year (published in the Federal
Reserve Bulletin H.15). See ARM Note.

CURRENT INDEX The most recently available Index published 30 calendar
days before the Change Date.

CHANGE DATE The effective date of an adjustment to the interest rate
(called the Interest Rate Adjustment Date by Ginnie Mae). The date is
specified in paragraph 5(A) of the ARM Note. (This is not the date on
which monthly payments change.)

11

MARGIN The agreed upon number of percentage points added to the Current
Index to determine the Calculated Interest Rate. The number is specified
in paragraph 5(C) of the ARM Note, and remains constant for the life of
the mortgage.

INITIAL INTEREST The interest rate stated in the note that will be in
effect from the date of the

RATE first monthly payment for the initial:

12 to 18 months on a 1- year ARM,

> 36 to 42 months on a 3- year ARM,
>
> 60 to 66 months on a 5- year ARM,

84 to 90 months on a 7- year ARM, and

120 to 126 months on a 10- year ARM

(See Frequency of Interest Rate Changes above.)

CALCULATED The Current Index plus the Margin, rounded to the nearest
one-eighth

INTEREST RATE of one percentage point (0.125%). The Calculated Interest
Rate is used to determine the Adjusted Interest Rate.

ADJUSTED The new interest rate effective for the twelve month period
following INTEREST RATE each Change Date. (The Adjusted Interest Rate
will become the Existing

> Interest Rate on the next Change Date.)

EXISTING The interest rate in effect immediately prior to any adjustment
on the

INTEREST RATE pending Change Date.

If you have any questions about this Mortgagee Letter, please contact
your local Homeownership Center in Atlanta (888-696-4687), Denver
(800-543-9378), Philadelphia

(800-440-8647), or Santa Ana (888-827-5605).

Sincerely,

John C. Weicher

Assistant Secretary for Housing-

Federal Housing Commissioner