McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER5CHAPTER5 CHAPTER5CHAPTER5 Adjustable Rate Mortgages

McGraw-Hill/Irwin©2008 The McGraw-Hill Companies, All Rights Reserved

CHAPTER

5

CHAPTER

5Adjustable Rate

Mortgages

5-2

Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved

FRMs and Lender ConsiderationsFRMs and Lender Considerations

• Maturity gap Banks borrow short and lend long

• Lenders assume all interest rate risks in a FRM contract Unexpected change in the risk-free interest

rates• Inflation and real rate

Uncertainty about risk premia• Credit spread• Liquidity premium

• In high inflation environment, CPM hard to qualify due to mortgage “tilt effect”

5-3


Price level adjusted mortgagePrice level adjusted mortgage

• PLAM helps the lender to deal with inflation risk

• Mortgage balance and payments go up at the rate of inflation

• New payment computed using adjusted balance Interest rate constant

5-4


Shared Appreciation MortgageShared Appreciation Mortgage• Lender agrees to lower mortgage rate and

participates in property appreciation as a compensation Appreciation shared upon home sales or mortgage

maturity Lender does not share depreciation

• Example 8% FRM plus 50% of the appreciation vs. 10% FRM with no shared appreciation

• Q: At 4% inflation, what are the expected yields at 10 year expected stay? Assuming all loans are interest-only with 10 year

term at 80% LTV

5-5


Shared Appreciation MortgageShared Appreciation Mortgage

• Issues: It might take years for lenders to receive

compensation Lenders are concerned about how well home

will be maintained• Moral hazard problem

Tax deductibility Treatment of Qualified Major Home

Improvement (QMHI)• http://library.hsh.com/?row_id=59

5-6


ARM CharacteristicsARM Characteristics

• Initial interest rate

• Adjustment interval

• Index

• Margin

• Composite rate

• Caps and negative amortization

• Floors

5-7


ARM CharacteristicsARM Characteristics

• Initial interest rate Sometimes called the start rate or the

contract rate or interest. If lower than prevailing rates sometimes

called a teaser rate of interest• Accrual rate (to compute interest payment)

might be higher than teaser rate

• Payment shock

• Adjustment interval usually six months or one year

5-8


• Mortgage interest rates indexed to other market interest rates 6 month, 1 year, 3 year, 5 year treasury LIBOR Prime rate Weighted average cost of funds National average of existing loans

ARM Characteristics ContinuedARM Characteristics Continued

5-9



• Margin - a constant spread, or premium in addition to the index

• Composite rate = index + margin, sometimes called the market rate

• Caps - maximum increases allowed in payments or interest rates between adjustment intervals Payment caps; interest rate caps; Initial adjustment cap / annual cap / lifetime caps

5-10



• Negative Amortization due to payment caps Additions to the outstanding loan balance Q: Can interest cap create negative amortization?

• Floors - maximum reductions in payments or interest rates between adjustment intervals

5-11


Adjustable Rate MortgagesAdjustable Rate Mortgages

• Hybrid ARMs (3/1, 5/1, 7/1, and 10/1) Longer initial reset period Interest Only Hybrid ARM

• I.O. for initial reset period

• I.O. Option ARM Borrower choice

• Pay interest only

• Pay interest & some principal

• Pay less than interest: negative amortization typically specifies maximum negative amortization allowed

• Fully amortizing payments required in future

5-12


ARMs and Interest Rate RisksARMs and Interest Rate Risks

• As the lender assumes less interest rate risk, the borrower assumes more interest rate risk Lender passes fluctuation in costs of funds to

the borrower

• ARMs do not eliminate all interest rate risks for the lenders

5-13


Adjustable Rate Mortgages Adjustable Rate Mortgages Yield & Rates Yield & Rates

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

5-14


ARMs - Other Considerations ContinuedARMs - Other Considerations Continued

• Short term indices are riskier to borrowers than long term indices

• Shorter adjustment periods are riskier to borrowers

• Caps on payment / interest rate adjustments favor the borrower

• Small floors favor the lender• Negative amortization is risky for the lender

5-15


ARMs - Other ConsiderationsARMs - Other Considerations

• From the perspective of a lender, relative to FRMs, for ARMS: Interest rate risk is lower Default risk is higher Total risk premium is (usually) lower

• At time of origination, the expected yield on an ARM is usually lower than on a FRM

5-16


Three ARMs: An ExampleThree ARMs: An Example

• All have 30 year maturity, annual adjustment, 1 year T-bill index, 2% margin, 2 discount points

• ARM1 : no caps• ARM2: 7.5% payment caps; no interest caps;

negative amortization allowed• ARM3: 2% (annual) and 5% (lifetime) interest

rate caps• Q: Which ARM is riskier for the lender?

5-17


Example ContinuedExample Continued

• If the expected interest rates in year 2-5 are 10%, 13%, 15%, and 10%, and the three ARMs have starting interest rates of 8%, 9% and 11%, what are the payments and mortgage balances?

• Q: Why is the payment in year 5 different from year 2 for the 1st ARM?

5-18


Example ContinuedExample Continued

• APR for ARMs assumes that the future index rate over the life of the ARM will be the same as the index at origination.

• Q: What is the APR for the 1st ARM?

• Q: Can APR be lower than introductory rate for ARM? If so when?

• Q: What is the effective yield/cost for the mortgages if the borrower stays 5 years?

Documents

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER5CHAPTER5 CHAPTER5CHAPTER5 Adjustable Rate Mortgages