Chapter 6 Alternative Mortgage Instruments © OnCourse Learning

Chapter 6

Alternative Mortgage Instruments

© OnCourse Learning

Chapter 6 Learning Objectives

Understand alternative mortgage instruments (AMIs)

Understand how the standard mortgage terms are determined and how they are interrelated.

Understand how the characteristics of various AMIs solve the problems of a fixed-rate mortgage (FRM)

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Alternative Mortgage Instruments

Adjustable-Rate Mortgage (ARM)

Graduated-Payment Mortgage (GPM)

Price-Level Adjusted Mortgage (PLAM)

Shared Appreciation Mortgage (SAM)

Reverse Annuity Mortgage (RAM)

Pledged-Account Mortgage or Flexible Loan Insurance Program (FLIP)


Adjustable-Rate Mortgage (ARM)

Most popular AMI designed to solve the interest rate risk problem

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

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


ARM Variables Index – CMT Index (e.g. 1-year T-bill); LIBOR; COFI; the 11th District Cost of

Funds Index

Margin – amount, in bps, added to the index to obtain the contract rate

Adjustment Period

Interest Rate Caps Periodic (or rate)

Life-of-loan or life

First adjustment

Convertibility (to FRM)

Negative Amortization – increase in the loan balance from one period to the next

Teaser Rate – initial period discount


Determining The Contract Rate Fully Indexed:

Contract Rate (i) = Index + Margin

In general, the contract rate in time n is the lower ofin= Index + Margin

or

in = in-1 + Cap


ARM Example Loan Amount = $100,000

Index = 1-Year TB Yield

One Year Adjustable

Margin = 2.50

Term = 30 years

2/6 Interest Rate Caps

Monthly Payments

Teaser Rate = 5%


ARM Payment In Year 1 Index0 = 5%

Pmt1 = $100,000 (MC5/12,360) = $536.82


ARM Payment In Year 2 BalanceEOY1= 536.82 (PVAIF5/12,348) = $98,525

Interest Rate for Year 2

IndexEOY1 = 6%

i = 6 + 2.50 = 8.5%

or

i = 5 + 2 = 7%

Payment2 = $98,525 (MC7/12,348) = $662.21


ARM Payment In Year 3 BalanceEOY2 = $662.21 (PVAIF7/12,336) = $97,440

Interest Rate for Year 3

IndexEOY2 = 6.5%

i = 6.5 + 2.5 = 9%

or

i = 7 + 2 = 9%

Pmt3 = 97,440 (MC9/12,336) = $795.41


Simplifying Assumption

Suppose Index3-30 = 6.5%

This means that i3-30 = 9% since the contract rate in year 3 is fully indexed

Thus Pmt3-30 = $795.41

BalEOY3 = $96,632


ARM Effective Cost for a Three-Year Holding Period

$100,000 = 536.82 (PVAIFi/12,12)

+ 662.21 (PVAIFi/12,12) (PVIFi/12,12)

+ 795.41 (PVAIFi/12,12) (PVIFi/12,24)

+ 96,632 (PVIFi/12,36)

i = 6.89% The equation can be solved for i either by financial calculator

or by an iterative process of trial and error When using financial calculator, the cash flow mode is required since

payments are different each year


ARM Annual Percentage Rate (APR)

$100,000 = 536.82 (PVAIFi/12,12)+662.21 (PVAIFi/12,12) (PVIFi/12,12)

+795.41 (PVAIFi/12,336) (PVIFi/12,24)

i = 8.40%


Interest-Only ARM

Payment in the initial period is interest-only with no repayment of principal

After the initial period the loan becomes fully amortizing

Loan is designed to fully amortize over its stated term A 3/1 Interest-Only ARM is interest-only for the first

three years and then becomes a fully amortizing one-year ARM


Interest-Only ARM

Suppose you take a 3/1 interest-only ARM for $120,000, monthly payments, 30-year term. The initial contract rate is 4.00% and the contract rate for year 4 is 6.00%. The lender charges two discount points.


Interest-Only ARM

What is the monthly payment for the interest-only period?

$120,000 (.04/12) = $400.00


Interest-Only ARM

What is the effective cost of the loan if it is repaid at the EOY3?

120,000 – 2,400 = 400 (PVAIFi/12,36) + 120,000 (PVIFi/12,36)

i = 4.72%


Interest-Only ARM

What is the payment for year 4?

Pmt = 120,000 (MC6/12,324)

Pmt = $748.78


Interest-Only ARM

What is the balance of the loan at the EOY4 of the 30-year term?

BalEOY4 = 748.78 (PVAIF6/12,312)

= $118,165


Interest-Only ARM

If the loan is repaid at the EOY4, what is the effective cost?

120,000 – 2,400 = 400 (PVAIFi/12,36)

+ 748.78 (PVAIFi/12,12)

+ 118,165 (PVIFi/12,48)

i = 5.0145%


Option ARM

Gives the borrower the flexibility of several payment options each month

Includes a “minimum” payment, an interest-only payment, and a fully Amortizing payment

Usually has a low introductory contract rate Minimum payment results in negative amortization


Option ARM

Minimum payment can result in “payment shock” when payment increases sharply

Loan must be recast to fully amortizing every five or ten years

Negative amortization maximum of 125% of original loan balance

Loan payment increases to fully amortizing level


Alt-A Loan

Alternative Documentation Loan or “No Doc” Loan Borrower may not provide income verification or

documentation of assets Loan approval based primarily on credit score In the mid-2000s, loans were popular with non

owner-occupied housing investors


Flexible Payment ARM

Very low initial payment, expected to rise over time “Payment shock” with dramatic increase in payment Appeal is the very low initial payment designed to help

offset affordability problem Contract rate adjusts monthly with maybe no limits on

size of interest rate changes



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

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



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

GPMs generally experience negative amortization in the early years

Historically, FHA has had popular GPM programs Eliminating tilt effect allows borrowers to qualify for

more funds Biggest problem is negative amortization and effect on

loan-to-value ratio


Price-Level Adjusted Mortgage (PLAM)

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

The contract rate is the real rate The loan balance is adjusted to reflect changes in

inflation on an ex-post basis Lower contract rate versus negative amortization


PLAM Example

EOY Inflation1 4%

2 -3%

3 2%

4-30 0%


Suppose you borrow $100,000 for 30 years, monthly payments. The current real rate is 6% with annual payment adjustments

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PLAM Example

Pmt in year 1 = $100,000 ( MC6/12,360) = $599.55

Pmt in year 2BalEOY1 = $98,772 (1.04) = $102,723

Pmt2 = $102,723 (MC6/12,348) = $623.53

Pmt in year 3BalEOY2 = $101,367 (.97) = $98,326

Pmt3 = $98,326 (MC6/12,336) = $604.83

PLAM Example (Cont.)

Pmt in year 4BalEOY3 = $96,930 (1.02) = $98,868

Pmt4 = $98,868 (MC6/12,324) = $616.92

Pmt in year 5-30BalEOY4 = $97,356 (1.00) = $97,356

Pmt5-30 = $97,356 (MC6/12,312) = $616.92


PLAM Effective Cost If Repaid at EOY3 $100,000 = 599.55 (PVAIFi/12,12)

+ 623.53 (PVAIFi/12,12) (PVIFi/12,12)

+ 604.83 (PVAIFi/12,12) (PVIFi/12,24)

+ 98,868 (PVIFi/12,36)

i = 6.97%


PLAM Effective Cost If Held To Maturity (APR)

$100,000 = 599.55 (PVAIFi/12,12)+ 623.53 (PVAIFi/12,12) (PVIFi/12,12)

+ 604.83 (PVAIFi/12,12) (PVIFi/12,24)

+ 616.92 (PVAIFi/12,324) (PVIFi/12,36)

i = 6.24%



Problems with PLAM

Payments increase at a faster rate than income

Mortgage balance increases at a faster rate than price appreciation

Adjustment to mortgage balance is not tax deductible for borrower

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

Dual Index Mortgage (DIM) Uses more than one index for adjustment

Borrower’s rate tied to wage and salary index Lender’s rate tied to interest rate index If the borrower’s payment does not catch up with lender’s

payment – balance at maturity

From lender’s standpoint similar to the ARM From borrower’s standpoint not comparable to ARM

E.g. borrower’s initial payment low based on the a low interest rate, but rate due to lender higher – results in negative amortization


Shared Appreciation Mortgage (SAM)

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

Reduction in contract rate is related to share of appreciation Amount of appreciation is determined when the house is sold or by

appraisal on a predetermined future date


Reverse Mortgage Typical Mortgage

Borrower receives a lump sum up front and repays in a series of payments

“Falling Debt, Rising Equity”

Reverse Mortgage Borrower receives a series of payments and repays in a lump sum at some future

time

“Rising Debt, Falling Equity”


Reverse Mortgage

Loan advances are not taxable

Designed for senior homeowners for little or no mortgage debt

Social Security benefits are generally not affected

Interest is deductible when paid



Reverse Mortgage

Reverse Mortgage Can Be: A cash advance

A line of credit

A monthly annuity

Some combination of above


Reverse Mortgage 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.

Pledged-Account Mortgage

Also called the Flexible Loan Insurance Program (FLIP) Combines a deposit with the lender with a fixed-rate

loan to form a graduated-payment structure Deposit is pledged as collateral with the house May result in lower payments for the borrower and

thus greater affordability


Home Equity Loans Typically revolving credit lines in which the borrower’s

home serves as collateral Have specific credit limits based on the borrower’s quality Once the loan approved the borrower can draw any

amount up to the limit at any point of time Minimum payment required based on agreed

amortization period Generally, combined LTV of first and second mortgage

should not exceed 80% of the house value


AMIs and Tax Deductibility of Interest Payments

With standard loan all interest payments are deducible With some AMIs borrowers (as cash-basis taxpayers)

may not use fully interest deductions E.g. with GPM: In initial years interest expense > payment The borrower cannot deduct the excess of interest charge

over the amount of payment. The deduction is deferred until positive amortization begins


Mortgage Refinancing

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

Borrowers will most often refinance when market rates are low

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



Factors that are known to the borrower or can be calculated from the existing mortgage contract: Current contract rate

Current payment

Current remaining term

Current outstanding balance



Assumptions that must be made by the borrower: What will be the amount of the new loan?

Payoff of the existing loan?

Payoff of the existing loan plus financing costs of the new loan?

Payoff of the existing loan plus financing costs of the new loan plus equity to be taken out?



Assumptions that must be made by the borrower: What will be the term of the new loan?

Equal to the remaining term of the existing loan?

Longer than the remaining term of the existing loan?

Shorter than the remaining term of the existing loan?




Assumptions that must be made by the borrower: What will be the holding period of the financing?

Equal to the term (maturity) of the mortgage?

Shorter than the term (maturity) of the mortgage?

Refinancing Example $100,000 30-year FRM at 10%, paid monthly, 3% prepayment penalty if

repaid in the first 8 years Consider refinancing in 5 yrs into 25-year FRM at 7.5%; 3% financing costs Calculations:

Current payment: $877.57

Payoff of existing loan =

= Balance + Prepayment Penalty = $96,574 + 2,897 = $99,471

New loan payment: $735.08

Monthly payment savings = $877.57 - 735.08 = $142.49

New loan financing costs = 3%*$99,471=$3,979

NPV of refinancing = $142.49 (PVAIF7.5/12,300) - $3,979 = $15,302


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Chapter 6 Alternative Mortgage Instruments © OnCourse Learning