Chapter 6

Report
Chapter 6
Alternative Mortgage
Instruments
6-1
Chapter 6
Learning Objectives
Understand alternative mortgage
instruments
 Understand how the characteristics of
various AMIs solve the problems of a
fixed-rate mortgage

6-2
Interest Rate Risk
Mortgage Example:
 $100,000 @ 8% for 30 years, monthly
payments


PMT = $100,000 ( MC8,30) = $733.76
6-3
Interest Rate Risk

If the market rate goes to 10%, the market
value of this mortgage goes to:
 PV = $733.76 (PVAF10/12,360) = $83,613

Lender loses $16,387
6-4
Interest Rate Risk

If the lender could automatically adjust
the contract rate to the market rate
(10%), the market value of the loan
remains
 Pmt = $100,000 (MC10,30) = $877.57
 PV = $877.57 (PVAF10/12,360) =
$100,000
Alternative Mortgage
Instruments
Adjustable-Rate Mortgage (ARM)
 Graduated-Payment Mortgage (GPM)
 Price-Level Adjusted Mortgage (PLAM)
 Shared Appreciation Mortgage (SAM)
 Reverse Annuity Mortgage (RAM)
 Pledged-Account Mortgage or Flexible
Loan Insurance Program (FLIP)

Adjustable-Rate Mortgage
(ARM)
Designed to solve interest rate risk problem
 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
 Provisions to limit rate changes
 Initial rate is generally less than FRM rate

6-5
ARM Variables
Index
 Margin
 Adjustment Period
 Interest Rate Caps



Periodic
Lifetime
Convertibility
 Negative Amortization
 Teaser Rate

6-6
Determining The Contract
Rate
Fully Indexed:
 Contract Rate = i = Index + Margin
 In general, the contract rate is

 in=
Index + Margin
or
 in = in-1 + Cap


whichever is lower
6-7
ARM Example
Loan Amount = $100,000
 Index = 1 year TB yield
 One year adjustable
 Margin = 2.50
 Term = 30 years
 2/6 Interest rate caps
 Monthly payments
 Teaser Rate = 5%

6-8
A. ARM Payment In Year One
Index0 = 5%
 Pmt1 = $100,000 (MC5,30) = $536.82

6-9
B. ARM Payment In Year Two

BalanceEOY1= 536.82 (PVAF5/12,348) = $98,525
Interest Rate for Year Two
 IndexEOY1 = 6%
 i = 6 + 2.50 = 8.5%
 or
 i = 5 + 2 = 7%
 Payment2 = $98,525 (MC7,29) = $662.21

6-10
C. ARM Pmt In Year 3
BalanceEOY2 = $662.21 (PVAF7/12,336) =
$97,440
 IndexEOY2 = 6.5%
 i = 6.5 + 2.5 = 9%
 i = 7 + 2 = 9%
 Pmt3 = 97440 (MC9,28) = $795.41

6-11
Simplifying Assumption

Suppose Index3-30 = 6.5%

This means that i3-30 = 9%

Thus Pmt3-30 = $795.41

BalEOY3 = $96,632
6-12
ARM Effective Cost-Hold for
3 Years

$100,000 = 536.82 (PVAFi/12,12)
+ 662.21 (PVAFi/12,12) (PVFi/12,12)
 + 795.41 (PVAFi/12,12) (PVFi/12,24)
 + 96,632 (PVFi/12,36)


i = 6.89%
6-13

ARM Effective Cost-Hold
to Maturity
$100,000 = 536.82 (PVAFi/12,12)
+662.21 (PVAFi/12,12) (PVFi/12,12)
 +795.41 (PVAFi/12,336) (PVFi/12,24)


i = 8.40%
Graduated-Payment Mortgage
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
 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





After several years the payments level off for
the remainder of the term
GPMs generally experience negative
amortization in the early years
Historically, FHA has had popular GPM
programs
Eliminating tilt effect allows borrowers to
qualify for more funds
Biggest problem is negative amortization and
effect on loan-to-value ratio
Price-Level Adjusted Mortgage
(PLAM)
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
 The contract rate is the real rate
 The loan balance is adjusted to reflect
changes in inflation on an ex-post basis
 Lower contract rate versus negative
amortization

6-14
PLAM Example
Borrow $100,000 for 30 years, monthly
payments. Current Real Rate = 6% with
Annual Payment Adjustments

Inflation




4%
-3%
2%
0%

EOY




1
2
3
4-30
6-15
A. PLAM Pmt in year 1

Pmt = $100,000 ( MC6,30) = $599.5
6-16
B. PLAM Pmt in year 2

BalEOY1 = $98,772 (1.04) = $102,723

Pmt2 = $102,723 (MC6,29) = $623.53
6-17
C. PLAM Pmt in year 3

BalEOY2 = $101,367 (.97) = $98,326

Pmt3 = $98,326 (MC6,28) = $604.83
6-18
D. PLAM Pmt in year 4

BalEOY3 = $96,930 (1.02) = $98,868

Pmt4 = $98,868 (MC6,27) = $616.92
6-19
E. PLAM Pmt in years 5-30

BalEOY4 = $97,356 (1.00) = $97,356

Pmt5-30 = $97,356 (MC6,26) = $616.92
F. PLAM Effective Cost If
Repaid at EOY3
6-20

$100,000 = 599.55 (PVAFi/12,12)
+ 623.53 (PVAFi/12,12) (PVFi/12,12)
 + 604.83 (PVAFi/12,12) (PVFi/12,24)
 + 98,868 (PVFi/12,36)


i = 6.97%
G. PLAM Effective Cost If
Held To Maturity
6-21

$100,000 = 599.55 (PVAFi/12,12)
+ 623.53 (PVAFi/12,12) (PVFi/12,12)
 + 604.83 (PVAFi/12,12) (PVFi/12,24)
 + 616.92 (PVAFi/12,324) (PVFi/12,36)


i = 6.24%
Problems with PLAM
6-22
Payments increase at a faster rate than
income
 Mortgage balance increases at a faster
rate than price appreciation
 Adjustment to mortgage balance is not
tax deductible for borrower
 Adjustment to mortgage balance is
interest to lender and is taxed
immediately though not received

Shared Appreciation Mortgage
(SAM)
Low initial contract rate with inflation
premium collected later in a lump sum
based on house price appreciation
 Reduction in contract rate is related to
share of appreciation
 Amount of appreciation is determined
when the house is sold or by appraisal
on a predetermined future date

6-23
RAM Characteristics
Typical Mortgage - Borrower receives a
lump sum up front and repays in a
series of payments
 RAM - Borrower receives a series of
payments and repays in a lump sum at
some future time

6-25
RAM Characteristics
Typical Mortgage - “ Falling Debt, Rising
Equity”
 RAM - “ Rising Debt, Falling Equity”





Designed for retired homeowners with little or no
mortgage debt
Loan advances are not taxable
Social Security benefits are generally not affected
Interest is deductible when actually paid
RAM Characteristics
6-26

RAM Can Be:
 A cash advance
 A line of credit
 A monthly annuity
 Some combination of above
6-27
RAM Example
Borrow $200,000 at 9% for 5 years, Annual Pmts.
Yr
1
2
3
4
5
Beg. Bal. Pmt
Interest End Bal.
0
30659
2759
33418
33418
30659
5767
69844
69844
30659
9045 109548
109548
30659
12619 152826
152826
30659
16514 199999
Pledged-Account Mortgage
Also called the Flexible Loan Insurance
Program (FLIP)
 Combines a deposit with the lender with a
fixed-rate loan to form a graduated-payment
structure
 Deposit is pledged as collateral with the
house
 May result in lower payments for the
borrower and thus greater affordability

Mortgage Refinancing
Replaces an existing mortgage with a new
mortgage without a property transaction
 Borrowers will most often refinance when
market rates are low
 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)


similar documents