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Adjustable Rate Mortgages: Payment Patterns and Interest Rate Risks

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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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