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Mortgage Designs

Mortgage Designs. Katie Schuberg And Lisa Shannon. Agenda. Fixed Rate Mortgage (FRMs) Two main issues with FRMs Adjustable Rate Mortgage (ARMs) Interest Only Balloon/Reset Mortgage Sub-Prime Mortgage Subprime Meltdown. Importance of Understanding Mortgage Designs.

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Mortgage Designs

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  1. Mortgage Designs Katie Schuberg And Lisa Shannon

  2. Agenda • Fixed Rate Mortgage (FRMs) • Two main issues with FRMs • Adjustable Rate Mortgage (ARMs) • Interest Only • Balloon/Reset Mortgage • Sub-Prime Mortgage • Subprime Meltdown

  3. Importance of Understanding Mortgage Designs • 97% of houses purchased in 2001 were funded through loans • Only 1.6% were purchased using cash • As we have seen in recent events different mortgage designs can cause a dramatic effect on the United States economy! • “U.S. foreclosures reached 274,399 in January, the 10th straight month in which more than a quarter-million filings were processed, RealtyTrac Inc., the Irvine, California-based provider of real estate data, said in a statement yesterday. Foreclosure filings soared to a record last year, surging 81 percent to 2.3 million, as home prices fell and mortgage standards tightened. “ • http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aC7x_GWO2ic8

  4. Fixed Rate Mortgage System • Pay interest and principal in equal installments over a determined period of time. • Most traditional mortgage design; though it is not the most popular. • Was the founding mortgage design; the following mortgages took off from the principals behind the FRM

  5. Two main issues of Fixed Rate Mortgages • Mismatch Problem • Concept of borrowing short and lending long. • Interest rate risk: Risk that depository institutions will misjudge future interest rates and take positions that may create a negative spread when rates change. • Tilt Problem • Fixed payments create a greater burden at the beginning of mortgage.

  6. Mortgage Design Comparison

  7. Adjustable-Rate Mortgage System (ARMs) • Most popular design in the United States • Interest rates are reset every month, six months, every year, two years, or longer • Shifts the interest rate risk from the lender to the borrower • Do not know how the interest rates are going to react in the markets

  8. ARMs continued • Interest Rate Caps and Floors • Rate Cap • Limits the amount that the interest rate may increase or decrease at the reset date (typically expressed in percentage points). • Rate Floors • The lowest amounts charged on the lifetime of the loan

  9. Adjustable Rate Mortgage Adjustable vs. Fixed Mortgages Fixed Rate Mortgage Amount of the loan: $  250,000 Annual percentage rate of interest:   7% Number of years:     30 Payment Information: Your monthly mortgage payment will be: $ 1663.26

  10. Interest Only Loans • ARM design in where payments are comprised of just interest for the first period of the loan, typically five years. • In that first period no equity is earned besides the initial down-payment. • Enables payments to be notably lower than those of a traditional mortgage design. • Payment comparison • What issues can you foresee with a design like this?

  11. Additional Mortgage Designs • Primarily deal with the tilt problem of the FRM • Payments account for inflation • Graduated-payment mortgage- nominal payments increase each month for portion of loan and then level off at fixed rate. • Price-level-adjusted mortgage- payments fixed at real rate opposed to nominal rate (price level measured on index) • Dual-rate mortgage- payments start very low then rise at rate of inflation( computed on floating short-term rate)

  12. Balloon/Reset Mortgages • Borrower is given a long term financing, but at the specified date (which is a while before the actual maturity date of the mortgage) the loan is paid off and the lender agrees to continue financing for the remainder of the term at a new mortgage rate. • Lender and borrow figure out re-negotiation periods at the time the contract is written up • At the time of re-negotiation, they decide what the new interest rates are going to be

  13. Sub-prime Mortgage System • For people with lower credit ratings (typically below 600) • Do not qualify for conventional design (FRM) • These people did qualify for the non-traditional mortgages • Payment option ARMs • Interest only mortgages • Balloon mortgages • Because: • Lenders lessened standards to subprime candidates • High default risk • Affordable payments with record-low interest rates

  14. Sub-prime Meltdown • However, the historical low rates at time of issuance increased throughout the 3 to 5 year period. • Borrowers faced with much higher payments • + high default risk • + housing market depreciation • = Sub-prime Meltdown

  15. Explain why someone would want to choose: -Fixed rate mortgage -Adjustable rate mortgage -Interest only mortgage -Balloon/reset mortgage

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