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Adjustable-Rate Mortgages

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- An adjustable-rate mortgage is a loan on which the periodic contractual interest rate can change over the life of the loan.
- The rate is reset periodically to a fixed spread (called the margin) over a benchmark or reference rate.
- Most common reference rate is short term Treasury rate as determined by current market conditions.
- LIBOR

- Others include calculated cost of funds or average mortgage rates

- Most common reference rate is short term Treasury rate as determined by current market conditions.

- The rate is reset periodically to a fixed spread (called the margin) over a benchmark or reference rate.

October 1, 2007

- Interest Rate Risk
- In the early 1980s, lenders were burned by holding long term fixed-rate mortgages while interest rates rose.
- “Heads I Win; Tails You Lose” game
- Unanticipated transfer of wealth from lenders (savers) to borrowers.

- Lenders wanted to modify the mortgage contract to share the risk between lender and borrower more fairly.

- In the early 1980s, lenders were burned by holding long term fixed-rate mortgages while interest rates rose.

- “Tilt Problem”
- When inflation is high, lenders need to build in expected inflation into the loan rate.
- Nominal rate= real rate + expected inflation rate + risk adjustment

- When inflation is high, this means the borrower must make high “real” payments at the start of the loan and low “real” payments at the end of the loan.
- Makes it hard for borrowers to qualify for loans

- When inflation is high, lenders need to build in expected inflation into the loan rate.

- Yield Curve:
- In normal times, it costs more to borrow money at a fixed rate for a long time period than for a short time period.
- Some borrowers only expect to need a loan for a period less than thirty years.
- ARMs should be priced more like short term borrowings.

Treasury Yield Curve

Source: ustreas.gov

- The periodic rate on an ARM is typically set as a fixed spread over an index or benchmark rate.
- For example, the rate on a mortgage can be set at 2.75% over the one-year Treasury rate.
- To find the rate on the loan, we look up the one year Treasury rate (say 6.10%) and add 2.75% to it to get a rate of 8.85% .
- The periodic rate is fixed at 8.85/12 for twelve months. At that point, it adjusts to 2.75% above the then current one year Treasury rate
- If Treasury rate has fallen to 4.5%, the mortgage rate could fall to 7.25%

- For example, the rate on a mortgage can be set at 2.75% over the one-year Treasury rate.

- The spread over the index is called the loan’s margin.
- The margin on an adjustable rate loan is an important factor in determining the true cost of an ARM.
- Try to find the margin required by lenders in many loan advertisements.

- The margin on an adjustable rate loan is an important factor in determining the true cost of an ARM.

Example of 1 Year ARM (No Caps)

Note, each payment is calculated based on the Loan Rate

Shown above, the remaining balance due after amortization

and the remaining term=30-t

- In order to provide some protection for borrowers, ARMs provide limits on how much the loan rate and/or payment can change.
- Lifetime limits or caps on how high the interest rate can rise
- Life caps are often in the 5% to 6% range

- Periodic rate caps limit how much the rate can change at any one time
- Periodic caps are often in the 1% to 2% range

- Lifetime limits or caps on how high the interest rate can rise

- When an ARM has rate caps, you can think of the adjustment process as having three steps:
- Step 1: Calculate the rate as if there were no caps: Index+Margin
- Step 2: See if the rate calculated in step 1 exceeds the lifetime cap on the loan. If it does, reduce the number from step 1 to the maximum allowable limit.
- Step 3: See if the change from the current rate to the rate calculated in step 2 exceeds the periodic limit. If it does, set the rate equal to the old rate plus (or minus) the periodic limit.

Calculating the Rate on a Capped ARM

Lifetime Cap=5% over original loan rate

Periodic Cap=+/- 2%

- Notice that although rates in the future are set by a formula of index + margin, subject to caps, the borrower and lender are free to set the initial rate at any level they want.
- In this example, we have set it at the current index rate plus the margin.
- Most lenders offer initial rates that are lower than index + margin
- These lower rates are often called “Teaser Rates”

- Teaser rates
- lower the borrower’s initial monthly payment
- lower the lifetime cap if it is specified as the initial rate plus a certain %
- Build in expected increases in payments over time if rates do not change.

Effect of Teaser Rate on ARM Adjustment

Say the Initial Rate is set ay 6%--2.85% below fully-indexed rate.

ARM Amortization if Rates Stay Constant

ARM Amortization if Rates Rise

ARM Amortization if Rates Fall

- What if instead of limiting how much the interest rate could increase, we limited how much the payment could increase.
- For example, we could say the borrower’s payment will never increase by more than 15% in any one year.
- If payment cap restricts the size of the monthly payment:
- as long as payment > interest due, then (payment - interest) >0 loan amortizes
- more slowly than normal

- if payment < interest due in the month, then (payment-interest) < 0 and loan balance increases
- Ending balance= beginning balance-(payment-Interest)

- as long as payment > interest due, then (payment - interest) >0 loan amortizes

Negative Amortization from a 15% Payment Cap

- Lenders earn market rate at all times
- Interest is accrued at the market rate even when the loan is negatively amortizing

- Borrower can plan for the “worst case” in the next year’s payment increase
- Rules of Thumb (for interest rates around 4.5%)
- 7.5% payment cap --- 2/3 of 1% interest rate cap
- 15% payment cap --- 1.25% interest rate cap
- 25% payment cap --- 2.00% interest rate cap

- Lenders generally impose limits on the amount of negative amortization.
- Maximum % increase over original loan or linked to original house value
- Payment caps removed near the end of the loan and loan is recast.

- Historically (at least before Payment Option Loans)
- Borrowers did not like negative amortization
- They often voluntarily paid a larger payment

- Default rates on neg. am ARMs were much higher than on fully amortizing ARMs and Fixed Rate Mortgages

- Borrowers did not like negative amortization
- Neg. Am ARMs with payment caps are not common in today’s market.
- However, payment option loans that give the borrower several choices each month have been quite popular in the last few years
- Borrower can choose from
- Low minimum payment (often based on an initial teaser rate of 1-2% that only applied for 1-3 months)
- Paying just the interest due that month
- Paying the fully amortizing payment

- See posted article about Countrywide’s CEO Comments on customer’s choices of payment on payment-option loans

- Borrower can choose from

- However, payment option loans that give the borrower several choices each month have been quite popular in the last few years

Pay Option Loans

From 9/16/07 Hartford Courant Rates Page

- ARMs without periodic interest rate caps or payment caps are best for reducing the lender’s interest rate risk.
- Assuming no borrowers default from payment shock

- ARMs with payment caps and no periodic interest rate caps reduce the default risk from payment shock but increase the risk that the loan amount will exceed the collateral value.
- ARMs with tighter periodic interest rate caps increase the lender’s interest rate risk, but reduce the default risk
- FRMs can be viewed as the limiting loan type as the rate caps get tighter

- ARMs can be classified by how frequently they adjust the rate and the index they adjust to.
- Periodicity
- monthly, 6 months, annually, every three years, every five years

- Fixed/Adjustable
- Many ARMs have an initial period where the loan rate is fixed and then begin to adjust
- 3/1, 5/1,10/1
- 2/28

- Many ARMs have an initial period where the loan rate is fixed and then begin to adjust

- Periodicity

- Some common indexes used for ARMs:
- Treasury securities
- 6 month, 1 year, 3 year, 5 year

- LIBOR
- Cost of Funds at Thrift Institutions
- COFI (11th district)

- National average rate on new mortgage loans (FHFB Contract Rate)
- Fannie Mae or Freddie Mac purchase yields for new loans

- Treasury securities

- With a 275 bp margin and today’s 1 year Treasury rate (about 4.05%), fully indexed cost of an ARM is about 6.80%
- Initial “Teaser” Rates are 3.875% – to 6.50%
- See www.hicentral.com and check mortgage rates

- All reported loans have initial rate < fully indexed rate
- When Treasury rates were at their low points, “teasers” were negative
- Relation to greater consumer demand for ARMs?

- When Treasury rates were at their low points, “teasers” were negative

- Mean Coupon Rate: 5.35%
- Mean APR: 7.28, range (6.48-8.60)

- Mean Coupon Rate: 6.01% range (4.75-6.125)
- Mean APR : 6.24%, range (5.90-6.50)

- ARMs are popular
- a. When the yield curve is very steep so that loans priced off the short end of the yield curve appear to be less costly than fixed rate loans
- b. When FRM rates are cyclically high
- ARMs are more affordable
- Borrower’s may expect to “roll down” to a lower fixed-rate after paying the low teaser rate for a couple of years.

- When house prices rise more rapidly than income creating affordability problems
- Review the mortgage origination data from the first week and see if you can sort out when ARMs are popular and when they are not

- ARMs with teaser rates have lower initial monthly payments
- They let more people qualify for loans
- They let people buy bigger houses than they could otherwise afford
- They are the primary product available for
- Jumbo borrowers
- Subprime borrowers

Recent ARM Share Data from Freddie Mac

Freddie’s survey focuses exclusively on

conventional conforming mortgages and so

provides a lower estimate of ARM share

than you would find if you included jumbo

& subprime sectors

HSH Checklist for When You Should Choose an ARM

Is an ARM Right for You?

If you haven't considered an ARM before, you certainly should. The short checklist below will help you to determine if some form of ARM might be for you. Just check any that apply:

My job has required more than one transfer in the past ten years I bought / am buying a "starter home" I'm planning on having more children / occupants than my home has bedrooms I'm single, young and buying a condo or apartment I'm a potential retiree in the next ten years I think rates will fall in the next few years I have trouble qualifying for a fixed rate mortgage at today's rates I expect to move or expand my home within seven years I'm getting a jumbo mortgage I have elderly relatives whose care I may be responsible for soon

A checkmark on at least some of these questions indicates that you probably won't be holding a 30-year FRM for anywhere near 30 years. You may expand your home, move, refinance, retire and move or want more productive cash flow. All of these argue in favor of some form of ARM.

- Many other mortgage types exist:
- GPM
- PLAM
- GEM
- SAM

- Each loan type is designed to make a better, more marketable, loan for the borrower

- A graduated payment mortgage is a fixed rate loan with a payment that starts out below the regular amortizing payment and is scheduled to increase each year
- 5%-7.5% /year for roughly 5 years
- Loan negatively amortizes in the first few years and then payment increases to the point that loan is fully amortized by the 30 year maturity

- A Growing Equity mortgage is a fixed-rate loan where the borrower increases the payment over time with the extra payment reducing the principal and shortening the maturity of the loan

- A shared appreciation mortgage is a fixed-rate mortgage where the borrower agrees to share the expected appreciation in house price over time with the lender in return for a lower interst rate on the loan

- A price level adjusted mortgage is effectively a variable rate loan.
- Borrower agrees to pay a low “real” rate of interest excluding the inflation premium
- At the end of each year, the balance of the loan is adjusted (usually increased) to reflect the inflation that occurred in a given year
- The borrower’s payment is adjusted to amortize the new balance over the remaining term