1 / 30

Chapter 5

Chapter 5. Adjustable Rate Mortgage Loans (ARMs) and other Alternatives to Fixed Rate Mortgages. Review of determinants of mortgage interest rate. Real risk-free rate (no inflation and no risk) Plus expected inflation (over loan term) Plus risk premiums: Unexpected inflation

vince
Download Presentation

Chapter 5

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 5 Adjustable Rate Mortgage Loans (ARMs) and other Alternatives to Fixed Rate Mortgages

  2. Review of determinants of mortgage interest rate Real risk-free rate (no inflation and no risk) Plus expected inflation (over loan term) Plus risk premiums: Unexpected inflation Interest rate risk -- market > contract Prepayment risk -- market < contract Default risk -- income < payment prop value < mortgage balance Low for ARM vs. FRM for lender Higher for ARM?

  3. Inflation Tilt with Fixed Rate Mortgages $100,000 loan, 30 year amort, 4% real rate, 10% nominal rate with 6% inflation 877.57 Nominal payments, 6% expected inflation Real payments, 6% inflation 477.41 Nominal payments, no inflation Time Periods of high expected inflation increase the real mortgage payments in early periods (relative to zero inflation).

  4. Price Level Adjusted Mortgage Contract interest rate is a “real” interest rate rather than nominal At the end of each year the balance is adjusted for any inflation, e.g., if inflation was 3% the previous year the balance is increased by 3%. Payments are re-calculated for the remaining loan term using the adjusted balance but the original real interest rate.

  5. Problem 1 at end of chapter • $95,000 PLAM with 4% real contract rate, 30 year amortization. Inflation is 6%. • Initial payment is $453.54 • Balance after 1 year is $93,327.02 • Adjust balance for inflation: $93,327.02 x 1.06 = $98,926.64 • New payment $98,926.64 for 29 years at 4% is $480.76 (about 6% higher)

  6. PLAM Payment Nominal payment Real payment

  7. PLAM Balance

  8. Adjustable Rate Mortgages (ARMs) • Interest rate risk shifted from lender to borrower by tying rate to index like LIBOR. • If interest rates rise the rate on the ARM rises • If interest rates fall the rate on the ARM falls – but borrowers could refinance if no prepayment penalty • So main difference from FRM is the risk of interest rates increasing. • Borrowers need to be compensated for taking this risk through a lower interest rate on the ARM • Why is it less risky for lenders if interest rate is uncertain?

  9. Examples of ARM Indices • Interest rates on 6-month T-bills. • Interest rates on one-year, 3 year or 5 year T-bond • Prime lending rate, LIBOR • 11th District Cost of Funds Index* *This index reflects the weighted-average interest rate paid by 11th Federal Home Loan Bank District savings institutions for savings and checking accounts, advances from the FHLB, and other sources of funds. The 11th District represents institutions headquartered in Arizona, California and Nevada.

  10. Margin Lenders add a ‘margin’ to the prevailing index to account for the risks associated with default Depending on the security which the rate is linked to - the margins range from 1.5 to 3.5 percentage points on average. Composite Rate = Index + Margin 11

  11. Factors affecting rate • Type of index (based on short or long term rates) • Margin over index (when fully indexed) • Initial margin (teaser) • Frequency of adjustment (annual, every 2 yrs, etc.) • Interest rate caps and floors • Payment caps and floors (can result in negative amortization) if just a cap on payments (not interest) • Expected future interest rates (term structure)

  12. Main types of ARM • Unrestricted – no limit on how much payments or interest rates can increase or decrease • Interest rate cap – limit on the amount that the interest rate for the ARM can increase – payments are based on the capped interest rate • Annual cap • Lifetime cap • Payment cap (but no interest rate cap) – limits increase in payments but interest still charged at the uncapped rate – can result in negative amortization

  13. Ch5 ARM No Caps

  14. Ch5 ARM Int Cap

  15. Ch5 ARM Pmt Cap

  16. ARM Alternatives • Portion of loan fixed and portion adjustable • Hybrid ARM - Starts off fixed and then becomes adjustable • Starts of adjustable with option to shift to fixed rate after X years • Adjustable with option to choose whether to make the entire payment each month

  17. Option ARM • Interest adjusts monthly • Payment options each month • Regular payment • Interest only • Minimum payment (less than interest) resulting in negative amortization • Minimum payment may increase each year, e.g., 7.5% • After 5 or 10 years the minimum payment usually recast to amortize the loan over the remaining term.

  18. A Summary of Variable Rate Mortgages and Risk The shorter the maturity of the index - the more volatile the underlying index - the more risk that is being borne by the borrower. The more frequent the adjustment period - the more risk that is being borne by the borrower. If there are no interest rate caps - the more risk that is being borne by the borrower. Payment caps with negative amortization do not reduce the risk to the borrower.

  19. Summary of Mortgage Types • Fixed Rate Mortgage (FRM) • Interest only • Constant amortization mortgage (CAM) • Constant payment mortgage (CPM) • Graduated payment mortgage (GPM) • Other payment patterns, e.g., negative amortization • Adjustable Rate Mortgage (ARM) • Unrestricted • Interest cap • Payment cap • Price Level Adjusted Mortgage (PLAM)

  20. Selecting a Mortgage Alternative - factors to consider • Expected time loan will be held • Expected change in interest rates • Expected inflation • Expected change in home value • Expected change in personal income • Risk aversion of borrower • Other loans held by borrower

  21. Example Get a mortgage for $100,000. No points. Option 1: Get a 30 year mortgage with amortization period = 30 years at 10% annual, compounded monthly. PMT = 877.57 Option 2: Get a 7 year mortgage with a 30 year amortization period for 9.5% annual, compounded monthly. PMT = 840.85 Which would I prefer?

  22. What type of loan*? • Job with good income, but not consistent month to month • Loan to consider: Option ARM • Why? Flexibility in payment *From bankrate.com website

  23. What type of Loan? • Buying for the long haul • Loan to consider: 30-year fixed rate • Why? Peace of mind

  24. What type of loan? • Recent graduate with strong potential for increased earnings • Loan to consider: One-year ARM with caps • Why: Stretch your dollars with low interest rates during the years when your income is at its leanest. Caps limit increases.

  25. What type of Loan? • Planning to live in home 4 or 5 years • Loan to consider: A 5/25 hybrid loan • Why: If you won't keep the loan longer than five years, why pay extra to lock in an interest rate for a longer period?

  26. What type of Loan? • Job relocation for a short run (with good income and savings) • Loan to consider: Interest-only mortgage • Why: While these loans can be risky for novice borrowers or those stretching to afford a home, they can be a smart tool for financially sophisticated borrowers who already have assets built up. Monthly payments are low because you're not repaying principal, so you can afford a larger loan.

  27. To be considered later • Buy down loans – money given to lender to reduce payments for X years • Participation loans – lender shares in the income from the property and / or increase in the value of the property • Convertible loans – lender can convert loan balance into X% ownership in the property

More Related