1 chapter 5 adjustable rate mortgages. 2 overview adjustable rate mortgages and lender...

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Chapter 5

Adjustable Rate Mortgages

2

Overview

Adjustable Rate Mortgages and Lender Considerations

Interest Rate Risk of Constant Payment Mortgages

Price Level Adjusted Mortgage (PLAM)

Adjustable Rate Mortgages (ARM) ARM Effective Yield

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Adjustable Rate Mortgages and Lender Considerations

The need for adjustable rate mortgage instruments The interest rate risk of constant payment mortgages is

tested in 1970s when inflation accelerated Thrifts (Savings and Loan Associations) borrow funds short-

term at low rates then invest in long-term fixed rate mortgages (Maturity mismatch)

As long as short-term rates are low, this works fine What happens if short-term rates rise (inflationary

expectations) (1) Maturity mismatch will cause severe problems

First, market value of constant payment mortgage portfolio will be less

Second, prepayment rate will slow reducing revenues from prepayments and penalties

(2) Tilt effect: Inflation fuels future inflationary expectations leading to high rates and payments on constant payment mortgages – Affordability problem

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Interest Rate Risk of Constant Payment Mortgages

An constant payment mortgage is just like a corporate bond: it’s value will change depending on the current market interest rates

Suppose that we own a mortgage loan with the following original term: $100,000, 30-year, 10%, monthly payments

The monthly payment on this loan is 877.57 After 5 years, the market interest rate is 12% The remaining (outstanding) balance of the loan is

96,574 What is the market value of the mortgage?

N I/Y P/Y PV PMT FV

300 12 12 -83,322.2

4

877.57 0

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Price Level Adjusted Mortgage (PLAM)

With the PLAM the lender receives the real rate of return as the contract rate on the loan

The lender then receives the premium for inflation through an upward adjustment on the remaining balance of the loan

The upward adjustment is equal to the rate of inflation over the previous year

Loan payment pattern depends on the inflation

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Price Level Adjusted Mortgage (PLAM) – Continued

Loan Amount $60,000.00Interest Rate 4.00%Loan Term 30Payment per Year 12Number of Payments 360

MonthBeginning

Loan Balance

Monthly Payment

Interest AmortizationEnding Loan

BalanceInflation

01 $60,000.00 $286.45 $200.00 $86.45 $59,913.55

11 $59,122.42 $286.45 $197.07 $89.37 $59,033.0512 $59,033.05 $286.45 $196.78 $89.67 $62,479.98 6.00%13 $62,479.98 $303.64 $208.27 $95.37 $62,384.6123 $61,511.85 $303.64 $205.04 $98.60 $61,413.2624 $61,413.26 $303.64 $204.71 $98.93 $64,993.19 6.00%25 $64,993.19 $321.85 $216.64 $105.21 $64,887.9835 $63,925.16 $321.85 $213.08 $108.77 $63,816.3936 $63,816.39 $321.85 $212.72 $109.13 $67,529.70 6.00%37 $67,529.70 $341.17 $225.10 $116.07 $67,413.63

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PLAM Payments

0

200

400

600

800

1000

1200

1400

1600

1800

0 12 24 36 48 60 72 84 96 108 120 132 144 156 168 180 192 204 216 228 240 252 264 276 288 300 312 324 336 348 360

Month

Mon

thly

Pay

men

t

Monthly Payment

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Price Level Adjusted Mortgage (PLAM) – Continued

Major shortcomings of the PLAM include: A relatively complicated loan instrument for the

average borrower Negative amortization that may occur if an

individual property price fails to rise with the level of general inflation upon which the annual adjustments to the balance are made

PLAMs may not completely solve the maturity mismatch problem unless financial intermediaries are able to issue price-level-adjusted deposits

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Adjustable Rate Mortgages (ARM)

ARM allows the interest rate on the loan to move with the market interest rate

Ability of adjusting the interest rate shifts the interest rate risk to the borrower

The lender’s interest rate risk is not completely eliminated because interest rate adjustments occur in periodic intervals

The longer the interval the greater the interest rate risk Borrowers would not assume all of the interest rate

risk. For that reason there will be caps on the interest rate

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Adjustable Rate Mortgages – Continued

A new loan payment is computed at each reset date Composite Rate = index + margin Index

Interest rate that the lender does not control Treasury securities Cost Of Funds Index (COFI) London Interbank Offered Rate (LIBOR)

Margin Premium added to the index

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Expected Start Rate Index plus margin on loan closing date. This rate is lower

than Fixed Rate Mortgage (FRM) rate since interest rate risk is lower for lender

Actual Start Rate Market driven and likely to be lower than expected start

rate Teaser Rate – low rate to attract borrowers

Reset Date When mortgage payment is readjusted

Negative Amortization Payment does not cover the interest due and inflates the

amount owed. The negative amortization may be allowed in the loan agreement

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Limits or Caps Maximum increases allowed in payments, interest

rates, maturity, and negative amortization Floors

Maximum reductions allowed in payments or rates Assumability Points Prepayment Conversion

Right of a borrower to convert ARM into FRM

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3/1, 5/1, and 7/1 Hybrid ARMs Longer initial reset period The extension of initial reset period will reduce the spread

between ARM and FRM rates Example: $100,000 with 6% initial rate for the first

3 years, monthly payments, and 30 years Payment per month for the first 3 years:

Balance of the loan after 3 years is 96,084 Payment for the following year assuming a new rate of 6.5%

N I/Y P/Y PV PMT FV

360 6 12 -100,00

0

599.55 0

N I/Y P/Y PV PMT FV

324 6.5 12 -96,084 629.88 0

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Interest Only Hybrid ARM I.O. for initial reset period

I.O. Option ARM Borrower choice

Pay interest only Pay interest & some principal Sometimes negative amortization occurs Fully amortizing payments required in future

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Adjustable Rate Mortgages Teaser Rate

Initial rate below market composite rate (index + margin)

Market Competition Accrual Rate – The loan payments are based on

teaser rate, however, balance of the loan increases by difference between market interest rate and teaser rate

Negative Amortization – The existence of accrual rate will cause negative amortization

Payment Shock – Significant increase in payment when there is a reset of interest rate

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Yield & Rates

Yields are a function of: Initial interest rate Index & margin Any points charged Frequency of reset date Any rate or payment limits

17Adju

stable

Rate

Mort

gage

Ris

ks

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Yield & Risks

Default Risk Can borrower afford new payments? Impact of negative amortization

Pricing Risk Allocation of interest rate risk Impact on default risk of specific

borrowers

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Yield & Risks Basic Relationships:

ARM yield is lower than FRM yield at origination otherwise no one would be willing to take interest rate risk

Short-term vs. long-term indices – short-term rate are more volatile than long-term rates. Less risk averse borrowers will prefer ARM based on a short-term index

Shorter reset periods vs. Longer reset periods – frequent rate adjustments reduce lender’s interest rate risk

Impact of caps & floors – they will reduce the borrower’s interest rate risk by limiting the adjustments

Negative amortization

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ARM ExamplesARM I ARM III

Initial interest rate, or start rate 8.00% 11.00%loan maturity 30 30Maturity of instrument making up index 1 year 1 yearPercent margin above index 2.00% 2.00%Adjustment interval, or reset date 1 year 1 yearPoints 2.00% 2.00%Payment cap None NoneAnnual interest rate cap None 2.00%Lifetime cap None 5.00%Negative amortization No No

BOY Index2 10.00%3 13.00%4 15.00%5 10.00%

BOY = Beginning Of Year

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ARM I – Payments / Balances

Loan Amount $60,000.00Initial Rate 8.00%Loan Term 30Payment per Year 12Number of Payments 360

Year 1 Payment:N I/Y P/Y PV PMT FV

360 8.00% 12 -60,000 440.26 0

Balance After 1 Year:N I/Y P/Y PV PMT FV

348 8.00% 12 59,499 440.26 0


348 12.00% 12 -59,499 614.24 0= Index + Margin

ARM I:

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ARM I – Payments / Balances – Continued Balance After 2 Years:

N I/Y P/Y PV PMT FV336 12.00% 12 59,255 614.24 0


336 15.00% 12 -59,255 752.26 0= Index + Margin

Balance After 3 Years:N I/Y P/Y PV PMT FV

324 15.00% 12 59,106 752.26 0


324 17.00% 12 -59,106 846.20 0= Index + Margin

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ARM I – Payments / Balances – Continued

Year Month Month Interest Payment Balance Index1 1 12 8.00% $440.26 $59,4992 13 24 12.00% $614.24 $59,255 10.00%3 25 36 15.00% $752.26 $59,106 13.00%4 37 48 17.00% $846.20 $58,991 15.00%5 49 60 12.00% $617.60 $58,639 10.00%

ARM I


312 17.00% 12 58,991 846.20 0


312 12.00% 12 -58,991 617.60 0= Index + Margin


300 12.00% 12 58,639 617.60 0

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ARM III – Payments / Balances

Loan Amount $60,000.00Initial Rate 11.00%Loan Term 30Payment per Year 12Number of Payments 360


360 11.00% 12 -60,000 571.39 0

Balance After 1 Year:N I/Y P/Y PV PMT FV

348 11.00% 12 59,730 571.39 0


348 12.00% 12 -59,730 616.63 0= MIN (Index + Margin, Previous Rate + Annual Cap, Initial Rate + Lifetime Cap)

ARM III:

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ARM III – Payments / Balances – Continued


336 12.00% 12 59,485 616.63 0


336 14.00% 12 -59,485 708.37 0= MIN (Index + Margin, Previous Rate + Annual Cap, Initial Rate + Lifetime Cap)Balance After 3 Years:

N I/Y P/Y PV PMT FV324 14.00% 12 59,301 708.37 0


324 16.00% 12 -59,301 801.65 0= MIN (Index + Margin, Previous Rate + Annual Cap, Initial Rate + Lifetime Cap)

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ARM III – Payments / Balances – Continued

Index Year Month Month Interest Payment Balance1 1 12 11.00% $571.39 $59,730

10.00% 2 13 24 12.00% $616.63 $59,48513.00% 3 25 36 14.00% $708.37 $59,30115.00% 4 37 48 16.00% $801.65 $59,15910.00% 5 49 60 12.00% $619.37 $58,807

ARM III


312 16.00% 12 59,159 801.65 0


312 12.00% 12 -59,159 619.37 0= MIN (Index + Margin, Previous Rate + Annual Cap, Initial Rate + Lifetime Cap)Balance After 5 Years:

N I/Y P/Y PV PMT FV300 12.00% 12 58,807 619.37 0

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ARM I Effective Yield

CF0 = -58,800.00C01 = 440.26 F01 = 12C02 = 614.24 F02 = 12C03 = 752.26 F03 = 12C04 = 846.20 F04 = 12C05 = 617.60 F05 = 11C06 = 59,256.86 F06 = 1

CPT IRR 1.0851 %Annual 13.02 %

ARM I

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ARM III Effective Yield

CF0 = -58,800.00C01 = 571.39 F01 = 12C02 = 616.63 F02 = 12C03 = 708.37 F03 = 12C04 = 801.65 F04 = 12C05 = 619.37 F05 = 11C06 = 59,426.10 F06 = 1

CPT IRR 1.1231 %Annual 13.48 %

ARM III

1 chapter 5 adjustable rate mortgages. 2 overview adjustable rate mortgages and lender...

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