ADJUSTABLE RATE AND VARIABLE PAYMENT MORTGAGES OBJECTIVES Calculate loan payments, loan balance, and interest charges on adjustable rate mortgages Effective cost of borrowing or lenders effective yield Calculate APR of an ARM Risks of both lender and borrower under an ARM

ARMs and Lender Considerations Fixed rate over life of the loan (FRMs) Unanticipated inflation Uncertainty about all risk premiums (prepayment) Unexpected change in the interest rates Maturity gap

Interest rates indexed to other market interest rates Terms are updated to current interest rate levels at the end of each adjustment period ARMs do not eliminate all interest rate risks Longer the adjustment period the greater the interest rate risk ARMs: An Overview

ARMs: An Overview Continued As the lender assumes less interest rate risk, the borrower assumes more interest rate risk

ARM Indexes Interest rates on six month treasury bills Interest rates on one year treasury bills Interest rates on three year treasury bills Interest rates on five year treasury bills Weighted average cost of funds National average of existing loans (fixed rate) LIBOR

ARM Characteristics Initial interest rate- sometimes called the start rate or the contract rate or interest. If lower than prevailing rates sometimes called a teaser rate of interest Index- stated in mortgages, as previously described Adjustment interval-usually six months or one year

ARM Characteristics Continued Margin- a constant spread, or premium in addition to the index Composite rate- the index plus the margin, sometimes called the market rate Limitation on caps- maximum increases allowed in payments or interest rates between adjustment intervals

ARM Characteristics Continued Negative Amortization- when additions to the outstanding loan balance are allowed Floors- maximum reductions in payments or interest rates Assumability Discount points Prepayment Privilege

ARMs- Other Considerations Both lenders and borrowers face uncertainty when making ARMs Risk premium Interest rate risk Default risk At time of origination the expected yield on an ARM should be less than on a FRM

Short term indexes are riskier to borrowers than long term indexes Shorter adjustment periods are riskier to borrowers Maximum caps on interest rate adjustments favor the borrower Borrowers should be careful of negative amortization ARMs- Other Considerations

Shared Appreciation Mortgage (SAM) Lender is compensated for increases in inflation Transfers much of the risk of price level increases to the borrower Lenders may wait years before receiving compensation Lenders are concerned about how well home will be maintained

Shared Appreciation Mortgage (SAM) Continued Appreciation in value of home depends on action of borrowers, such as maintenance Appreciation paid to a lender ruled a contingent interest