1. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER5CHAPTER5 CHAPTER5CHAPTER5 Adjustable Rate Mortgages

2. 5-2 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-3 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-4 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-5 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-6 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-7 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Adjustable Rate Mortgages Teaser Rate  Initial rate below market composite rate  Market Competition  Accrual Rate  Negative Amortization  Payment Shock

8. 5-8 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-9 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-10 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-11 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Adjustable Rate Mortgages Example 5-1  Unrestricted ARM  Loan Amount = $100,000  Starting Rate = 5%  Term = 30 Years  Adjustment Interval = 1 Year

12. 5-12 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Adjustable Rate Mortgages Initial Payment: = $100,000 = 360 = $0 = 5 = $536.82 n i CPT FV PMT PV

13. 5-13 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Adjustable Rate Mortgages EOY1 Loan Balance  Change n and compute the present value of the remaining payments = 348 = $98,524.63 n CPTPV

14. 5-14 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 n i CPT FV PMT PV

15. 5-15 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-16 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-17 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Adjustable Rate Mortgages Initial Payment: = $100,000 = 360 = $0 = 7 = $665.30 n i CPT FV PMT PV

18. 5-18 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-19 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-20 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-21 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Adjustable Rate Mortgages Initial Payment: = $100,000 = 360 = $0 = 6 = $599.55 n i CPT FV PMT PV

22. 5-22 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Adjustable Rate Mortgages EOY1 Loan Balance: = 348 = $98,771.99 n CPT PV

23. 5-23 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 5-24 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Adjustable Rate Mortgages If the Composite Rate = 10%, the unrestricted payment would be: = $98,771.99 = 348 = $0 = 10 = $871.64 n i CPT FV PMT PV

25. 5-25 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 n CPT FV PMT PV