Making sense of disclosures.

Explaining how a loan works is one of the most crucial tasks an originator does. Today's wide variety of loan programs--which include payment options and adjustable rates that change over time--makes the task of consumer education even harder.

Borrowers often try to make a decision

A June 2007 study released by the Federal Trade Commission (FTC), Improving Consumer Mortgage Disclosures, shows how difficult the mortgage process is for consumers. More than 800 recent mortgage borrowers around the country were given the Good Faith Estimate (GFE) disclosure form on a closed loan, and then questioned about that transaction.

Almost nine out of 10 couldn't identify the total upfront cost of the loan, and more than half couldn't uncover the loan amount. More than two out of three weren't aware the loan had a prepayment penalty, and 95 percent didn't know how much that penalty cost.

One in five consumers was unable to determine the amount of cash due at closing, or the monthly payment. Many consumers were unable to tell if the monthly payments included escrows for property taxes and homeowners insurance. One in three also wasn't aware that the mortgage had a large balloon payment due in the future.

Such widespread misunderstandings about an important financial document were "more of a problem than we ever would have guessed going in," says Janis Pappalardo, the study's co-author. Both prime and subprime borrowers struggled to interpret the standard disclosure forms, with almost no difference in their ability to fathom the disclosures.

What's more, the study dealt only with fixed-rate mortgage (FRM) loans. It's safe to assume borrowers would be even more confused when trying to figure out the parameters of an adjustable-rate mortgage (ARM) or an "exotic" loan offering several payment options. FTC Chairman Deborah Platt Majoras notes that mortgage forms were designed more than three decades ago, "and they do not address the variety and complexity of today's mortgage products."

Even though the FTC has no control over loan disclosures, the agency also provided consumers in the study with a revamped prototype disclosure form that highlights the loan type, amount and term. A loan's interest rate and upfront charges also are emphasized, along with cash due at closing, monthly payments and any scheduled balloon payments. Late and prepayment fees are spelled out, as well.

Borrowers also see the loan amount broken down to account for a home purchase or refi, cash taken out, debt consolidation, financed settlement charges and financed costs for other products or services. Additionally, they're informed that "optional charges," such as for credit life insurance, aren't required to obtain a loan and can be turned down. Monthly payments also are itemized to show the payment of principal and interest, property tax, homeowners insurance and other monthly charges.

Higher grades

Consumers who received the FTC's prototype form correctly answered 80 percent of the questions about the loan, compared with 61 percent for those who were given traditional loan disclosures. When asked what the total upfront cost was, just 13 percent answered accurately based on GFE information. But 78 percent of those given the prototype form could identify that amount.

Other alternatives to the GFE are being proposed. Alex Pollock, a resident fellow at the American Enterprise Institute (AEI), Washington, D.C., has come up with a one-page mortgage disclosure form. His format focuses on total closing costs and the monthly payment. Borrowers are told how long their start rate lasts and the maximum rate possible on their loan.

Pollock's form also shows the consumer's monthly household income and expresses total housing costs as a percentage of those earnings. Borrowers are told how that percentage would change if they were paying the maximum rate allowable on their mortgage, as well.

Pollock's intent is to help consumers understand how ARM adjustments will affect their budget. Simplification is important, he notes, because "trying to describe 100 percent of the details in specific legal terms in small print is likely to result in zero real information transfer to the borrower."

Other task forces that have looked into simplifying loan documents have found it's difficult to develop one format that will always provide meaningful information. Mortgages today are so varied--and consumers' financial situations also so different--that the key points of each transaction often must be spelled out individually to borrowers. Perhaps it's not surprising that many homeowners who now are struggling with resetting ARMs say they didn't understand what they were getting into when they signed their loan documents.

However, improving disclosures isn't a panacea. Consumer-friendly forms won't be very helpful if lender estimates about a loan's rate and settlement costs change between the time disclosures are made and the loan is ready to close. But they are a good first step.

Howard Schneider is a freelance writer based in Ojai, California. He can be reached at howard@mmnl.net.