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Chapter 5: ARMs

Chapter 5: ARMs. ARMs adjust the rate of interest periodically over the life of the mortgage. They shift the interest-rate risk from lender to borrower . In return for assuming more risk, the borrower usually gets a lower initial rate.

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Chapter 5: ARMs

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  1. Chapter 5: ARMs ARMs adjust the rate of interest periodically over the life of the mortgage. They shift the interest-rate risk from lender to borrower. In return for assuming more risk, the borrower usually gets a lower initial rate. ARMs may be beneficial to high net worth households who can assume more risks and to those who plan to move or refinance in a short time.

  2. Considerations with ARMs • Initial rate • Index (3 mo. T-bill rate, LIBOR rate • Margin or spread over the index • Adjustment interval • Rate caps (one-time & live-time): for example 1 & 5 or 2 & 6. • Payment caps, usually have negativeamortization.

  3. ARM Example: Term = 15 yrs., Initial Rate = 9%     Payments adjusted each year             Rate: No. Beg BalInterestPrincipalPMT 9.0% 1 75,000.00 562.50 198.20 760.70 9.0% 12 72,736.18 545.52 215.18 760.70 12.0% 13 72,521.00 725.21 167.84 893.04 12.0% 24 70,579.68 705.80 187.25 893.04 10.0% 25 70,392.43 586.60 221.39 808.00 Note: Each time you recalculate the payment, you must adjust the term to reflect the number of remaining payments.

  4. Initial Interest Rate = 10% Payment Cap = 5% per yr. Index = 1-yr T-bill Negative Amortization Payments adjusted each year Term = 30 years Margin = 2 percent Discount points = 2 % Uncap. Capped Rate: #Beg BalInterestPrincipalPMTPMT 10.0% 1 75,000.00 625.00 33.18 658.18 658.18 10.0% 12 74,619.44 621.83 36.35 658.18 658.18 12.0% 13 74,583.09 745.83 (54.74) 769.97 691.09 Note: in month 13, the capped payment can rise by only 5 percent.

  5. Other Kinds of Mortgages: • PLAM {Price level adjusted mortgage} is not available in U.S. Common in high-inflation countries like Brazil and Israel. With a PLAM, the outstanding balance is adjusted to reflect inflation, resulting in a higher nominal payment. For example, New Balance = Old Balance * inflation rate. • Shared Appreciation Mortgage (SAM)

  6. Other Kinds of Mortgages: • Reverse Annuity Mortgage (RAM): Provides annuity for older homeowners. • Interest-Only Mortgage (IOM): Borrower pays only interest each month, with balloon payment at the end. • Graduated Payment, Adjustable Rate Mortgage.

  7. Homework: Chapter 5 • Problems 2 & 3, page 143

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