Chapter 6 Alternative Mortgage Instruments

Chapter 6 Learning Objectives n Understand alternative mortgage instruments n Understand how the characteristics of various AMIs solve the problems of a fixed-rate mortgage

Interest Rate Risk n Mortgage Example: $100,000 Fixed-Rate 8% for 30 Years, Monthly Payments PMT = $100,000 ( MC 8,30 ) = $733.76

Interest Rate Risk n If the market rate immediately goes to 10%, the market value of this mortgage goes to: PV = $ (PVAF 10/12,360 ) = $83,613 n Lender loses $16,387

Interest Rate Risk n If the lender can adjust the contract rate to the market rate (10%), the payment increases and the market value of the loan stays constant: Pmt = $100,000 (MC 10,30 ) = $ PV = $ (PVAF 10/12,360 ) = $100,000

Alternative Mortgage Instruments n Adjustable-Rate Mortgage (ARM) n Graduated-Payment Mortgage (GPM) n Price-Level Adjusted Mortgage (PLAM) n Shared Appreciation Mortgage (SAM) n Reverse Annuity Mortgage (RAM) n Pledged-Account Mortgage or Flexible Loan Insurance Program (FLIP)

Adjustable-Rate Mortgage (ARM) n Designed to solve interest rate risk problem n Allows the lender to adjust the contract interest rate periodically to reflect changes in market interest rates. This change in the rate is generally reflected by a change in the monthly payment n Provisions to limit rate changes n Initial rate is generally less than FRM rate

ARM Variables n Index n Margin n Adjustment Period n Interest Rate Caps –Periodic –Lifetime n Convertibility n Negative Amortization n Teaser Rate

Determining The Contract Rate n Fully Indexed: Contract Rate (i) = Index + Margin n In general, the contract rate in time n is the lower of i n = Index + Margin or i n = i n-1 + Cap

ARM Example n Loan Amount = $100,000 n Index = 1-Year TB Yield n One Year Adjustable n Margin = 2.50 n Term = 30 years n 2/6 Interest Rate Caps n Monthly Payments n Teaser Rate = 5%

ARM Payment In Year 1 n Index 0 = 5% n Pmt 1 = $100,000 (MC 5,30 ) = $536.82

ARM Payment In Year 2 n Balance EOY1 = (PVAF 5/12,348 ) = $98,525 n Interest Rate for Year 2 Index EOY1 = 6% i = = 8.5% or i = = 7% n Payment 2 = $98,525 (MC 7,29 ) = $662.21

ARM Payment In Year 3 n Balance EOY2 = $ (PVAF 7/12,336 ) = $97,440 n Interest Rate for Year 3 n Index EOY2 = 6.5% i = = 9% or i = = 9% n Pmt 3 = 97,440 (MC 9,28 ) = $795.41

Simplifying Assumption n Suppose Index 3-30 = 6.5% n This means that i 3-30 = 9% since the contract rate in year 3 is fully indexed n Thus Pmt 3-30 = $ n Bal EOY3 = $96,632

ARM Effective Cost for a Three-Year Holding Period n $100,000 = (PVAF i/12,12 ) (PVAF i/12,12 ) (PVF i/12,12 ) (PVAF i/12,12 ) (PVF i/12,24 ) + 96,632 (PVF i/12,36 ) i = 6.89%

ARM Annual Percentage Rate (APR) n $100,000 = (PVAF i/12,12 ) (PVAF i/12,12 ) (PVF i/12,12 ) (PVAF i/12,336 ) (PVF i/12,24 ) i = 8.40%

Interest-Only ARM n Payment in the initial period is interest-only with no repayment of principal n After the initial period the loan becomes fully amortizing n Loan is designed to fully amortize over its stated term n A 3/1 Interest-Only ARM is interest-only for the first three years and then becomes a fully amortizing one-year ARM

Interest-Only ARM n Suppose you take a 3/1 interest-only ARM for $120,000, monthly payments, 30-year term. The initial contract rate is 4.00% and the contract rate for year 4 is 6.00%. The lender charges two discount points.

Interest-Only ARM What is the monthly payment for the interest-only period? $120,000 (.04/12) = $400.00

Interest-Only ARM What is the effective cost of the loan if it is repaid at the EOY3? 120,000 – 2,400 = 400 (PVAF i/12,36 ) + 120,000 (PVF i/12,36 ) i = 4.72%

Interest-Only ARM What is the payment for year 4? Pmt = 120,000 (MC 6,27 ) Pmt = $748.78

Interest-Only ARM What is the balance of the loan at the EOY 4 of the 30-year term? Bal EOY4 = (PVAF 6/12,312 ) = $118,165

Interest-Only ARM If the loan is repaid at the EOY4, what is the effective cost? 120,000 – 2,400 = 400 (PVAF i/12,36 ) (PVAF i/12,12 ) + 118,165 (PVF i/12,48 ) i = %

Option ARM n Gives the borrower the flexibility of several payment options each month n Includes a “minimum” payment, an interest- only payment, and a fully Amortizing payment n Usually has a low introductory contract rate n Minimum payment results in negative amortization

Option ARM n Minimum payment can result in “payment shock” when payment increases sharply n Loan must be recast to fully amortizing every five or ten years n Negative amortization maximum of 125% of original loan balance n Loan payment increases to fully amortizing level

Alt-A Loan n Alternative Documentation Loan or “No Doc” Loan n Borrower may not provide income verification or documentation of assets n Loan approval based primarily on credit score n In the mid-2000s, loans were popular with non owner-occupied housing investors

Flexible Payment ARM n Very low initial payment, expected to rise over time n “Payment shock” with dramatic increase in payment n Appeal is the very low initial payment designed to help offset affordability problem n Contract rate adjusts monthly with maybe no limits on size of interest rate changes

Graduated-Payment Mortgage (GPM) n Tilt effect is when current payments reflect future expected inflation. Current FRM payments reflect future expected inflation rates. Mortgage payment becomes a greater portion of the borrower’s income and may become burdensome n GPM is designed to offset the tilt effect by lowering the payments on an FRM in the early periods and graduating them up over time

Graduated-Payment Mortgage (GPM) n After several years the payments level off for the remainder of the term n GPMs generally experience negative amortization in the early years n Historically, FHA has had popular GPM programs n Eliminating tilt effect allows borrowers to qualify for more funds n Biggest problem is negative amortization and effect on loan-to-value ratio

Price-Level Adjusted Mortgage (PLAM) n Solves tilt problem and interest rate risk problem by separating the return to the lender into two parts: the real rate of return and the inflation rate n The contract rate is the real rate n The loan balance is adjusted to reflect changes in inflation on an ex-post basis n Lower contract rate versus negative amortization

PLAM Example n EOY n Inflation 4% -3% 2% 0% Suppose you borrow $100,000 for 30 years, monthly payments. The current real rate is 6% with annual payment adjustments

PLAM Payment in Year 1 PLAM Payment in Year 1 Pmt = $100,000 ( MC 6,30 ) = $599.55

PLAM Payment in Year 2 Bal EOY1 = $98,772 (1.04) = $102,723 Pmt 2 = $102,723 (MC 6,29 ) = $623.53

PLAM Payment in Year 3 Bal EOY2 = $101,367 (.97) = $98,326 Pmt 3 = $98,326 (MC 6,28 ) = $604.83

PLAM Payment in Year 4 Bal EOY3 = $96,930 (1.02) = $98,868 Pmt 4 = $98,868 (MC 6,27 ) = $616.92

PLAM Payment in Years 5-30 Bal EOY4 = $97,356 (1.00) = $97,356 Pmt 5-30 = $97,356 (MC 6,26 ) = $616.92

PLAM Effective Cost If Repaid at EOY3 n $100,000 = (PVAF i/12,12 ) (PVAF i/12,12 ) (PVF i/12,12 ) (PVAF i/12,12 ) (PVF i/12,24 ) + 98,868 (PVF i/12,36 ) i = 6.97%

PLAM Effective Cost If Held To Maturity (APR) n $100,000 = (PVAF i/12,12 ) (PVAF i/12,12 ) (PVF i/12,12 ) (PVAF i/12,12 ) (PVF i/12,24 ) (PVAF i/12,324 ) (PVF i/12,36 ) i = 6.24%

Problems with PLAM n Payments increase at a faster rate than income n Mortgage balance increases at a faster rate than price appreciation n Adjustment to mortgage balance is not tax deductible for borrower n Adjustment to mortgage balance is interest to lender and is taxed immediately though not received

Shared Appreciation Mortgage (SAM) n Low initial contract rate with inflation premium collected later in a lump sum based on house price appreciation n Reduction in contract rate is related to share of appreciation n Amount of appreciation is determined when the house is sold or by appraisal on a predetermined future date

Reverse Mortgage n Typical Mortgage - Borrower receives a lump sum up front and repays in a series of payments n Reverse Mortgage - Borrower receives a series of payments and repays in a lump sum at some future time

Reverse Mortgage n Typical Mortgage - “ Falling Debt, Rising Equity” n Reverse Mortgage - “ Rising Debt, Falling Equity”

Reverse Mortgage n Loan advances are not taxable n Designed for senior homeowners for little or no mortgage debt n Social Security benefits are generally not affected n Interest is deductible when paid

Reverse Mortgage n Reverse Mortgage Can Be: –A cash advance –A line of credit –A monthly annuity –Some combination of above

Reverse Mortgage Example Borrow $200,000 at 9% for 5 years, Annual Pmts.

Pledged-Account Mortgage n Also called the Flexible Loan Insurance Program (FLIP) n Combines a deposit with the lender with a fixed-rate loan to form a graduated-payment structure n Deposit is pledged as collateral with the house n May result in lower payments for the borrower and thus greater affordability

Mortgage Refinancing n Replaces an existing mortgage with a new mortgage without a property transaction n Borrowers will most often refinance when market rates are low n The refinancing decision compares the present value of the benefits (payment savings) to the present value of the costs (prepayment penalty on existing loan and financing costs on new loan)

Mortgage Refinancing n Factors that are known to the borrower or can be calculated from the existing mortgage contract: –Current contract rate –Current payment –Current remaining term –Current outstanding balance

Mortgage Refinancing n Assumptions that must be made by the borrower: –What will be the amount of the new loan? n Payoff of the existing loan? n Payoff of the existing loan plus financing costs of the new loan? n Payoff of the existing loan plus financing costs of the new loan plus equity to be taken out?

Mortgage Refinancing n Assumptions that must be made by the borrower: –What will be the term of the new loan? n Equal to the remaining term of the existing loan? n Longer than the remaining term of the existing loan? n Shorter than the remaining term of the existing loan?

Mortgage Refinancing n Assumptions that must be made by the borrower: –What will be the holding period of the financing? n Equal to the term (maturity) of the mortgage? n Shorter than the term (maturity) of the mortgage?