ADJUSTABLE RATE AND VARIABLE PAYMENT MORTGAGES OBJECTIVES

1. ADJUSTABLE RATE AND VARIABLE PAYMENT MORTGAGESOBJECTIVES • Calculate loan payments, loan balance, and interest charges on adjustable rate mortgages • Effective cost of borrowing or lenders effective yield • Calculate APR of an ARM • Risks of both lender and borrower under an ARM

2. ARMs and LenderConsiderations • Fixed rate over life of the loan (FRMs) • Unanticipated inflation • Uncertainty about all risk premiums (prepayment) • Unexpected change in the interest rates • Maturity gap

3. ARMs: An Overview • Interest rates indexed to other market interest rates • Terms are updated to current interest rate levels at the end of each adjustment period • ARMs do not eliminate all interest rate risks • Longer the adjustment period the greater the interest rate risk

4. ARMs: An Overview Continued • As the lender assumes less interest rate risk, the borrower assumes more interest rate risk

5. ARM Indexes • Interest rates on six month treasury bills • Interest rates on one year treasury bills • Interest rates on three year treasury bills • Interest rates on five year treasury bills • Weighted average cost of funds • National average of existing loans (fixed rate) • LIBOR

6. ARM 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 • Index- stated in mortgages, as previously described • Adjustment interval-usually six months or one year

7. ARM Characteristics Continued • Margin- a constant spread, or premium in addition to the index • Composite rate- the index plus the margin, sometimes called the market rate • Limitation on caps- maximum increases allowed in payments or interest rates between adjustment intervals

8. ARM Characteristics Continued • Negative Amortization- when additions to the outstanding loan balance are allowed • Floors- maximum reductions in payments or interest rates • Assumability • Discount points • Prepayment Privilege

9. ARMs- Other Considerations • Both lenders and borrowers face uncertainty when making ARMs • Risk premium • Interest rate risk • Default risk • At time of origination the expected yield on an ARM should be less than on a FRM

10. ARMs- Other Considerations • Short term indexes are riskier to borrowers than long term indexes • Shorter adjustment periods are riskier to borrowers • Maximum caps on interest rate adjustments favor the borrower • Borrowers should be careful of negative amortization

11. Shared Appreciation Mortgage (SAM) • Lender is compensated for increases in inflation • Transfers much of the risk of price level increases to the borrower • Lenders may wait years before receiving compensation • Lenders are concerned about how well home will be maintained

12. Shared Appreciation Mortgage (SAM) Continued • Appreciation in value of home depends on action of borrowers, such as maintenance • Appreciation paid to a lender ruled a contingent interest