CHAPTER 5 ADJUSTABLE RATE & VARIABLE PAYMENT MORTGAGES MORTGAGE LENDER’S DILEMMA (1970’s) MORTGAGE LENDER’S DILEMMA (1970’s) – RAPID INCREASES IN INFLATION (CAUSED “MATURITY CAP”) – INCREASED COMPETITION FOR DEPOSITORS’ SAVINGS SOLUTIONS SOLUTIONS – ALTERNATIVE MORTGAGE INVESTMENTS – SALE OF FRM ORIGINATIONS – DEREGULATION OF BANKING INDUSTRY

ADJUSTABLE RATE MORTGAGE (ARM): A MORTGAGE CHARACTERIZED BY AN INTEREST RATE THAT CAN MOVE EITHER UP OR DOWN DEPENDING ON THE AGREED-TO INDEX. A MORTGAGE CHARACTERIZED BY AN INTEREST RATE THAT CAN MOVE EITHER UP OR DOWN DEPENDING ON THE AGREED-TO INDEX. PURPOSE IS TO SHIFT INTEREST RATE RISK FROM LENDER TO BORROWER. PURPOSE IS TO SHIFT INTEREST RATE RISK FROM LENDER TO BORROWER.

ARM STRUCTURE: 1 ADJUSTMENT PERIOD - LENGTH OF TIME BEFORE THE INTEREST RATE AND PAYMENT CAN CHANGE (MOST COMMON PERIODS ARE 1, 3, 5 YEARS). GENERALLY SHORTER ADJUSTMENT INTERVALS MEAN LOWER INITIAL INTEREST RATE. 2 INDEX - THE INDEX WILL DETERMINE THE INTEREST RATE AND THEREFORE THE PAYMENT. THE INDEX IS BEYOND THE CONTROL OF THE LENDER: SIX-MONTH TREASURY BILL, ONE YEAR CONSTANT MATURITY TREASURY, THREE/FIVE YEAR TREASURY, FEDERAL HOME LOAN DISTRICT BANK COST OF FUNDS, ETC.

3 MARGIN - A CONSTANT PREMIUM ADDED TO INDEX RATE TO DETERMINE ARM INTEREST RATE (i.e. INDEX RATE AND MARGIN=ARM INTEREST RATE OR COMPOSITE RATE) 4 CAPS - LIMITATIONS ON INCREASES IN INTEREST RATES, PAYMENTS, MATURITY EXTENSIONS, AND NEGATIVE AMORTIZATION. PERIODIC CAPS SET LIMITS FROM ONE ADJUSTMENT PERIOD TO ANOTHER. LIFE-TIME CAPS LIMIT INCREASES OVER LIFE OF LOAN. FLOORS SET MAXIMUM REDUCTIONS

5 NEGATIVE AMORTIZATION - OCCURS WHEN PAYMENT CAPS ARE USED + PAYMENT CANNOT INCREASE ENOUGH TO PAY ALL THE INTEREST DUE ON THE MORTGAGE, THUS THE OUTSTANDING BALANCE INCREASES. 6 DISCOUNTS (“TEASER RATES”) - LOWERED INITIAL INTEREST RATE (AND THUS PAYMENT RATE) FROM THAT CALLED FOR BY ADDING TO TOGETHER THE INDEX+MARGIN. 7 SPREAD - DIFFERENCE BETWEEN RATES ARM + FRM ARE INITIALLY OFFERED (USUALLY BASIS POINTS)

REGULATION Z (TRUTH IN-LENDING) REQUIRES DISCLOSURE OF: INTEREST RATE CEILING INTEREST RATE CEILING BOOKLET EXPLAINING ARMS BOOKLET EXPLAINING ARMS 15 YEAR HISTORICAL EXAMPLE OF HOW RATES WOULD HAVE CHANGED 15 YEAR HISTORICAL EXAMPLE OF HOW RATES WOULD HAVE CHANGED WORST-CASE EXAMPLES WORST-CASE EXAMPLES

PROBLEMS WITH ARMS: 1 MORE COMPLEX AND DIFFICULT TO UNDERSTAND 2 BUDGET UNCERTAINTY FOR BORROWERS 3 INCREASED DEFAULT RISK 4 DON’T NECESSARILY ELIMINATE INTEREST RATE RISK TO LENDER IF WRONG INDEX IS CHOSEN, MARGINS ARE TOO SMALL, CEILING TOO LOW, ETC. · see text p. 145 (Exhibit 5-5)

YIELD/RISK RELATIONSHIPS: ARM “EXPECTED” YIELD SHOULD BE LESS THAN “EXPECTED” YIELD OF FRM DUE TO INTEREST RATE SHIFT. ARM “EXPECTED” YIELD SHOULD BE LESS THAN “EXPECTED” YIELD OF FRM DUE TO INTEREST RATE SHIFT. ARMS TIED TO SHORT-TERM INDEXES ARE RISKIER TO BORROWER - SHORT-TERM RATES ARE MORE VIOLATIBLE. ARMS TIED TO SHORT-TERM INDEXES ARE RISKIER TO BORROWER - SHORT-TERM RATES ARE MORE VIOLATIBLE. SHORTER ADJUSTMENT PERIODS ARE RISKIER FOR BORROWER SHORTER ADJUSTMENT PERIODS ARE RISKIER FOR BORROWER INTEREST RATE CAPS LOWER BORROWER INTEREST RATE RISK. INTEREST RATE CAPS LOWER BORROWER INTEREST RATE RISK. PAYMENT CAPS THAT CAUSE NEGATIVE AMORTIZATION DON’T REDUCE BORROWER INTEREST RATE RISK. PAYMENT CAPS THAT CAUSE NEGATIVE AMORTIZATION DON’T REDUCE BORROWER INTEREST RATE RISK.

BI-WEEKLY MORTGAGES: Example: Assume a $100,000 mortgage at 8% for 30 years. Loan Product Periodic Payment Term 30-year, monthly pmt $ months 30-year, monthly pmt $ months Biweekly payment $ months Biweekly payment $ months Interest saved with biweekly mortgage = $46,300.86

CONVERTIBLE MORTGAGES - ARM THAT IS CONVERTIBLE INTO FRM AT BORROWER’S OPTION USUALLY CONVERSION ALLOWED BETWEEN 13th MONTH AND 60th MONTH. USUALLY CONVERSION ALLOWED BETWEEN 13th MONTH AND 60th MONTH. CONVERSION FEE IS MUCH LOWER THAN COST TO REFINANCE. CONVERSION FEE IS MUCH LOWER THAN COST TO REFINANCE. CONVERTIBLE ARMS USUALLY HAVE INTEREST RATES BASIS POINTS ABOVE NORMAL ARMS. CONVERTIBLE ARMS USUALLY HAVE INTEREST RATES BASIS POINTS ABOVE NORMAL ARMS.

SHARED APPRECIATION MORTGAGES: LOWER INTEREST RATE FOR EQUITY INTEREST IN PROPERTY. LOWER INTEREST RATE FOR EQUITY INTEREST IN PROPERTY.