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CHAPTER 5

CHAPTER 5. Adjustable Rate Mortgages. Variable Payment Patterns. Fixed Rate Payment Patterns Interest Rate Risk Sharing Interest Rate Risk Price Level Adjusted Mortgage (PLAM) Loan balance adjusted for inflation New payment computed using adjusted balance. Adjustable Rate Mortgages.

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CHAPTER 5

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  1. CHAPTER5 Adjustable Rate Mortgages

  2. Variable Payment Patterns • Fixed Rate Payment Patterns • Interest Rate Risk • Sharing Interest Rate Risk • Price Level Adjusted Mortgage (PLAM) • Loan balance adjusted for inflation • New payment computed using adjusted balance

  3. Adjustable Rate Mortgages • 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

  4. Adjustable Rate Mortgages • Expected Start Rate • Index plus margin on loan closing date • Actual Start Rate • Market driven • Teaser Rate • Reset Date • When mortgage payment is readjusted

  5. Adjustable Rate Mortgages • Negative Amortization • Payment does not cover the interest due • Limits or Caps • Maximum increases allowed • Floors • Maximum reductions allowed • Assumability • Points • Prepayment • Conversion

  6. Adjustable Rate Mortgages • Hybrid ARMs • 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 • Sometimes negative amortization • Fully amortizing payments required in future

  7. Adjustable Rate Mortgages • Teaser Rate • Initial rate below market composite rate • Market Competition • Accrual Rate • Negative Amortization • Payment Shock

  8. Adjustable Rate Mortgages Yield & Rates • Yields are a function of: • Initial interest rate • Index & margin • Any points charged • Frequency of reset date • Any rate or payment limits

  9. Adjustable Rate Mortgages 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

  10. Adjustable Rate Mortgages Yield & Risks • Basic Relationships: • FRM vs. ARM yield at origination • Short-term vs. Long-term indices • Shorter reset periods vs. Longer reset periods • Impact of caps & floors • Negative amortization

  11. Adjustable Rate Mortgages • Example 5-1 • Unrestricted ARM • Loan Amount = $100,000 • Starting Rate = 5% • Term = 30 Years • Adjustment Interval = 1 Year

  12. Adjustable Rate Mortgages • Initial Payment: = $100,000 = 360 = $0 = 5 = $536.82 PV n FV i CPT PMT

  13. Adjustable Rate Mortgages • EOY1 Loan Balance • Change n and compute the present value of the remaining payments = 348 = $98,524.63 n CPT PV

  14. Adjustable Rate Mortgages • The new payment is based on loan balance of $98,524.63. • If the composite rate = 7%, = $98,524.63 = 348 = $0 = 7 = $662.21 PV n FV i CPT PMT

  15. Adjustable Rate Mortgages • Note the payment increase: $662.21 - $536.82 = $125.39 • This could be a problem for a borrower on a tight budget.

  16. Adjustable Rate Mortgages • Example 5-2: Interest Rate Caps • Loan Amount = $100,000 • Starting Rate = 7% • Term = 30 Years • Adjustment Interval = 1 Year • 2% Annual Rate Cap

  17. Adjustable Rate Mortgages • Initial Payment: = $100,000 = 360 = $0 = 7 = $665.30 PV n FV i CPT PMT

  18. Adjustable Rate Mortgages • EOY1 Loan Balance: = 348 = $98,984.19 • New payment is based on loan balance of $98,984.19. n CPT PV

  19. Adjustable Rate Mortgages • The new interest rate cannot be higher than 9% due to the interest rate cap. • If the Composite Rate = 10%, the 2% cap applies and the interest rate is 9%. • If the Composite Rate = 8%, the 2% cap does not apply and the interest rate is 8%.

  20. Adjustable Rate Mortgages • Example 5-3: Payment Caps • Loan Amount = $100,000 • Starting Rate = 6% • Term = 30 Years • Adjustment Interval = 1 Year • Payment Cap = 5%

  21. Adjustable Rate Mortgages • Initial Payment: = $100,000 = 360 = $0 = 6 = $599.55 PV n FV i CPT PMT

  22. Adjustable Rate Mortgages • EOY1 Loan Balance: = 348 = $98,771.99 n CPT PV

  23. Adjustable Rate Mortgages • New payment is based on loan balance of $98,771.99. • The dollar increase in the payment cannot exceed the capped payment. • Capped Payment = $599.55 x 1.05 = $629.53

  24. Adjustable Rate Mortgages • If the Composite Rate = 10%, the unrestricted payment would be: = $98,771.99 = 348 = $0 = 10 = $871.64 PV n FV i CPT PMT

  25. Adjustable Rate Mortgages • Since the capped payment is $629.53, it would be used. • If there is negative amortization, = $98,771.99 = 12 = $629.53 = $101,204.32 would be the EOY2 Loan Balance PV n PMT CPT FV

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