Chapter 6Chapter 6

Alternative Mortgage Alternative Mortgage InstrumentsInstruments

Chapter 6 Chapter 6 Learning ObjectivesLearning Objectives

Understand alternative mortgage Understand alternative mortgage instrumentsinstruments

Understand how the characteristics Understand how the characteristics of various AMIs solve the problems of various AMIs solve the problems of a fixed-rate mortgageof a fixed-rate mortgage

6-1

Interest Rate RiskInterest Rate Risk

Mortgage Example: Mortgage Example: $100,000 @ 8% for 30 years, monthly $100,000 @ 8% for 30 years, monthly

paymentspayments

PMT = $100,000 ( MCPMT = $100,000 ( MC8,308,30) = $733.76) = $733.76

6-2

Interest Rate RiskInterest Rate Risk

If the market rate goes to 10%, the If the market rate goes to 10%, the market value of this mortgage goes to:market value of this mortgage goes to: PV = $733.76 (PVAFPV = $733.76 (PVAF10/12,36010/12,360) = $83,613) = $83,613

Lender loses $16,387Lender loses $16,387

6-3

Interest Rate RiskInterest Rate Risk

If the lender could automatically If the lender could automatically adjust the contract rate to the market adjust the contract rate to the market rate (10%), the market value of the rate (10%), the market value of the loan remains loan remains Pmt = $100,000 (MCPmt = $100,000 (MC10,3010,30) = $877.57) = $877.57

PV = $877.57 (PVAFPV = $877.57 (PVAF10/12,36010/12,360) = ) = $100,000$100,000

6-4

Alternative Mortgage Alternative Mortgage InstrumentsInstruments

Adjustable-Rate Mortgage (ARM)Adjustable-Rate Mortgage (ARM) Graduated-Payment Mortgage (GPM)Graduated-Payment Mortgage (GPM) Price-Level Adjusted Mortgage (PLAM)Price-Level Adjusted Mortgage (PLAM) Shared Appreciation Mortgage (SAM)Shared Appreciation Mortgage (SAM) Reverse Annuity Mortgage (RAM)Reverse Annuity Mortgage (RAM) Pledged-Account Mortgage or Flexible Pledged-Account Mortgage or Flexible

Loan Insurance Program (FLIP)Loan Insurance Program (FLIP)

Adjustable-Rate Mortgage Adjustable-Rate Mortgage (ARM)(ARM)

Designed to solve interest rate risk Designed to solve interest rate risk problemproblem

Allows the lender to adjust the contract Allows the lender to adjust the contract interest rate periodically to reflect interest rate periodically to reflect changes in market interest rates. This changes in market interest rates. This change in the rate is generally reflected change in the rate is generally reflected by a change in the monthly paymentby a change in the monthly payment

Provisions to limit rate changesProvisions to limit rate changes Initial rate is generally less than FRM rateInitial rate is generally less than FRM rate

ARM VariablesARM Variables IndexIndex MarginMargin Adjustment PeriodAdjustment Period Interest Rate CapsInterest Rate Caps

Periodic Periodic LifetimeLifetime

ConvertibilityConvertibility Negative AmortizationNegative Amortization Teaser RateTeaser Rate

6-5

Determining The Determining The Contract RateContract Rate

Fully Indexed:Fully Indexed: Contract Rate = i = Index + MarginContract Rate = i = Index + Margin In general, the contract rate isIn general, the contract rate is

iinn= Index + Margin = Index + Margin oror iin n = i= in-1n-1 + Cap + Cap

whichever is lowerwhichever is lower

6-6

ARM ExampleARM Example Loan Amount = $100,000Loan Amount = $100,000 Index = 1 year TB yieldIndex = 1 year TB yield One year adjustableOne year adjustable Margin = 2.50Margin = 2.50 Term = 30 yearsTerm = 30 years 2/6 Interest rate caps2/6 Interest rate caps Monthly paymentsMonthly payments Teaser Rate = 5%Teaser Rate = 5%

6-7

A. ARM Payment In Year A. ARM Payment In Year OneOne

IndexIndex0 0 = 5%= 5%

PmtPmt1 1 = $100,000 (MC= $100,000 (MC5,305,30) = ) = $536.82$536.82

6-8

B. B. ARM Payment In Year ARM Payment In Year TwoTwo

BalanceBalanceEOY1EOY1= 536.82 (PVAF= 536.82 (PVAF5/12,3485/12,348) = ) = $98,525$98,525

Interest Rate for Year TwoInterest Rate for Year Two IndexIndexEOY1 EOY1 = 6%= 6% i = 6 + 2.50 = 8.5% i = 6 + 2.50 = 8.5% oror i = 5 + 2 = 7%i = 5 + 2 = 7%

PaymentPayment2 2 = $98,525 (MC= $98,525 (MC7,297,29) = $662.21) = $662.21

6-9

C. ARM Pmt In Year 3C. ARM Pmt In Year 3

BalanceBalanceEOY2 EOY2 = $662.21 (PVAF= $662.21 (PVAF7/12,3367/12,336) = ) = $97,440$97,440

IndexIndexEOY2 EOY2 = 6.5%= 6.5% i = 6.5 + 2.5 = 9%i = 6.5 + 2.5 = 9% i = 7 + 2 = 9%i = 7 + 2 = 9% PmtPmt3 3 = 97440 (MC= 97440 (MC9,289,28) = $795.41) = $795.41

6-10

Simplifying AssumptionSimplifying Assumption

Suppose IndexSuppose Index3-30 3-30 = 6.5%= 6.5%

This means that iThis means that i3-30 3-30 = 9%= 9%

Thus PmtThus Pmt3-30 3-30 = $795.41= $795.41

BalBalEOY3 EOY3 = $96,632= $96,632

6-11

ARM Effective Cost-Hold ARM Effective Cost-Hold for 3 Yearsfor 3 Years

$100,000 = 536.82 (PVAF$100,000 = 536.82 (PVAFi/12,12i/12,12) ) + 662.21 (PVAF+ 662.21 (PVAFi/12,12i/12,12) (PVF) (PVFi/12,12i/12,12))

+ 795.41 (PVAF+ 795.41 (PVAFi/12,12i/12,12) (PVF) (PVFi/12,24i/12,24))

+ 96,632 (PVF+ 96,632 (PVFi/12,36i/12,36))

i = 6.89%i = 6.89%

6-12

ARM Effective Cost-ARM Effective Cost-Hold to MaturityHold to Maturity

$100,000 = 536.82 (PVAF$100,000 = 536.82 (PVAFi/12,12i/12,12)) +662.21 (PVAF+662.21 (PVAFi/12,12i/12,12) (PVF) (PVFi/12,12i/12,12))

+795.41 (PVAF+795.41 (PVAFi/12,336i/12,336) (PVF) (PVFi/12,24i/12,24))

i = 8.40%i = 8.40%

6-13

Graduated-Payment Graduated-Payment MortgageMortgage

Tilt effect is when current payments Tilt effect is when current payments reflect future expected inflation. Current reflect future expected inflation. Current FRM payments reflect future expected FRM payments reflect future expected inflation rates. Mortgage payment inflation rates. Mortgage payment becomes a greater portion of the becomes a greater portion of the borrower’s income and may become borrower’s income and may become burdensomeburdensome

GPM is designed to offset the tilt effect by GPM is designed to offset the tilt effect by lowering the payments on an FRM in the lowering the payments on an FRM in the early periods and graduating them up early periods and graduating them up over timeover time

Graduated-Payment Graduated-Payment MortgageMortgage

After several years the payments level off After several years the payments level off for the remainder of the termfor the remainder of the term

GPMs generally experience negative GPMs generally experience negative amortization in the early yearsamortization in the early years

Historically, FHA has had popular GPM Historically, FHA has had popular GPM programsprograms

Eliminating tilt effect allows borrowers to Eliminating tilt effect allows borrowers to qualify for more fundsqualify for more funds

Biggest problem is negative amortization Biggest problem is negative amortization and effect on loan-to-value ratioand effect on loan-to-value ratio

Price-Level Adjusted Price-Level Adjusted Mortgage (PLAM)Mortgage (PLAM)

Solves tilt problem and interest rate risk Solves tilt problem and interest rate risk problem by separating the return to the problem by separating the return to the lender into two parts: the real rate of lender into two parts: the real rate of return and the inflation ratereturn and the inflation rate

The contract rate is the real rateThe contract rate is the real rate The loan balance is adjusted to reflect The loan balance is adjusted to reflect

changes in inflation on an ex-post basischanges in inflation on an ex-post basis Lower contract rate versus negative Lower contract rate versus negative

amortizationamortization

PLAM ExamplePLAM Example

InflationInflation 4%4% -3%-3% 2%2% 0%0%

EOYEOY 11 22 33 4-304-30

6-14

Borrow $100,000 for 30 years, monthly Borrow $100,000 for 30 years, monthly payments. Current Real Rate = 6% with payments. Current Real Rate = 6% with Annual Payment AdjustmentsAnnual Payment Adjustments

A. PLAM Pmt in year 1A. PLAM Pmt in year 1

Pmt = $100,000 ( MCPmt = $100,000 ( MC6,306,30) = $599.5) = $599.5

6-15

B. PLAM Pmt in year 2B. PLAM Pmt in year 2

BalBalEOY1 EOY1 = $98,772 (1.04) = = $98,772 (1.04) = $102,723$102,723

PmtPmt2 2 = $102,723 (MC= $102,723 (MC6,296,29) = ) = $623.53$623.53

6-16

C. PLAM Pmt in year 3C. PLAM Pmt in year 3

BalBalEOY2 EOY2 = $101,367 (.97) = $98,326= $101,367 (.97) = $98,326

PmtPmt3 3 = $98,326 (MC= $98,326 (MC6,286,28) = $604.83) = $604.83

6-17

D. PLAM Pmt in year 4D. PLAM Pmt in year 4

BalBalEOY3 EOY3 = $96,930 (1.02) = $98,868= $96,930 (1.02) = $98,868

PmtPmt4 4 = $98,868 (MC= $98,868 (MC6,276,27) = $616.92) = $616.92

6-18

E. PLAM Pmt in years 5-E. PLAM Pmt in years 5-3030

BalBalEOY4 EOY4 = $97,356 (1.00) = $97,356= $97,356 (1.00) = $97,356

PmtPmt5-30 5-30 = $97,356 (MC= $97,356 (MC6,266,26) = ) = $616.92$616.92

6-19

F. PLAM Effective Cost If F. PLAM Effective Cost If Repaid at EOY3Repaid at EOY3

$100,000 = 599.55 (PVAF$100,000 = 599.55 (PVAFi/12,12i/12,12)) + 623.53 (PVAF+ 623.53 (PVAFi/12,12i/12,12) (PVF) (PVFi/12,12i/12,12))

+ 604.83 (PVAF+ 604.83 (PVAFi/12,12i/12,12) (PVF) (PVFi/12,24i/12,24))

+ 98,868 (PVF+ 98,868 (PVFi/12,36i/12,36))

i = 6.97%i = 6.97%

6-20

G. PLAM Effective Cost If G. PLAM Effective Cost If Held To Maturity Held To Maturity

$100,000 = 599.55 (PVAF$100,000 = 599.55 (PVAFi/12,12i/12,12)) + 623.53 (PVAF+ 623.53 (PVAFi/12,12i/12,12) (PVF) (PVFi/12,12i/12,12))

+ 604.83 (PVAF+ 604.83 (PVAFi/12,12i/12,12) (PVF) (PVFi/12,24i/12,24))

+ 616.92 (PVAF+ 616.92 (PVAFi/12,324i/12,324) (PVF) (PVFi/12,36i/12,36))

i = 6.24%i = 6.24%

6-21

Problems with PLAMProblems with PLAM

Payments increase at a faster rate Payments increase at a faster rate than incomethan income

Mortgage balance increases at a Mortgage balance increases at a faster rate than price appreciationfaster rate than price appreciation

Adjustment to mortgage balance is Adjustment to mortgage balance is not tax deductible for borrowernot tax deductible for borrower

Adjustment to mortgage balance is Adjustment to mortgage balance is interest to lender and is taxed interest to lender and is taxed immediately though not receivedimmediately though not received

6-22

Shared Appreciation Shared Appreciation Mortgage (SAM)Mortgage (SAM)

Low initial contract rate with inflation Low initial contract rate with inflation premium collected later in a lump sum premium collected later in a lump sum based on house price appreciationbased on house price appreciation

Reduction in contract rate is related to Reduction in contract rate is related to share of appreciationshare of appreciation

Amount of appreciation is determined Amount of appreciation is determined when the house is sold or by appraisal when the house is sold or by appraisal on a predetermined future dateon a predetermined future date

RAM CharacteristicsRAM Characteristics

Typical Mortgage Typical Mortgage - Borrower - Borrower receives a lump sum up front and receives a lump sum up front and repays in a series of paymentsrepays in a series of payments

RAM RAM - Borrower receives a series - Borrower receives a series of payments and repays in a lump of payments and repays in a lump sum at some future timesum at some future time

6-23

RAM CharacteristicsRAM Characteristics

Typical Mortgage Typical Mortgage - “ Falling Debt, Rising - “ Falling Debt, Rising Equity”Equity”

RAM RAM - “ Rising Debt, Falling Equity”- “ Rising Debt, Falling Equity” Designed for retired homeowners with little Designed for retired homeowners with little

or no mortgage debtor no mortgage debt Loan advances are not taxableLoan advances are not taxable Social Security benefits are generally not Social Security benefits are generally not

affectedaffected Interest is deductible when actually paidInterest is deductible when actually paid

6-25

RAM CharacteristicsRAM Characteristics

RAM Can Be:RAM Can Be: A cash advance A cash advance A line of creditA line of credit A monthly annuityA monthly annuity Some combination of aboveSome combination of above

6-26

RAM ExampleRAM Example

Yr Beg. Bal. Pmt Interest End Bal.1 0 30659 2759 334182 33418 30659 5767 698443 69844 30659 9045 1095484 109548 30659 12619 1528265 152826 30659 16514 199999

Borrow $200,000 at 9% for 5 years, Annual Pmts.

6-27

Pledged-Account MortgagePledged-Account Mortgage

Also called the Flexible Loan Insurance Also called the Flexible Loan Insurance Program (FLIP)Program (FLIP)

Combines a deposit with the lender with Combines a deposit with the lender with a fixed-rate loan to form a graduated-a fixed-rate loan to form a graduated-payment structurepayment structure

Deposit is pledged as collateral with the Deposit is pledged as collateral with the househouse

May result in lower payments for the May result in lower payments for the borrower and thus greater affordabilityborrower and thus greater affordability

Mortgage RefinancingMortgage Refinancing

Replaces an existing mortgage with a new Replaces an existing mortgage with a new mortgage without a property transactionmortgage without a property transaction

Borrowers will most often refinance when Borrowers will most often refinance when market rates are lowmarket rates are low

The refinancing decision compares the The refinancing decision compares the present value of the benefits (payment present value of the benefits (payment savings) to the present value of the costs savings) to the present value of the costs (prepayment penalty on existing loan and (prepayment penalty on existing loan and financing costs on new loan)financing costs on new loan)