Alternative Mortgage Instruments: Understanding Adjustable-Rate Mortgages (ARMs) - Prof. T, Study notes of Finance

Download Alternative Mortgage Instruments: Understanding Adjustable-Rate Mortgages (ARMs) - Prof. T and more Study notes Finance in PDF only on Docsity! 1 Fin 4713 Chapter 6 Alternative Mortgage Instruments Chapter 6 Learning Objectives Understand alternative mortgage instruments Understand how the characteristics of various AMIs solve the problems of a fixed-rate mortgage Interest Rate Risk Mortgage Example: $100,000 @ 8% for 30 years, monthly payments PMT(PV=-$100000, N=36, I/YR=8) = $733.76 Interest Rate Risk If the market rate goes to 10%, the market value of this mortgage goes to (assuming amortized over the full term): PV(PMT= $733.76, I/YR=10, N=360) = $83,613 Lender loses $16,387 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(PV=100000, I/YR=10, N=360) = $877.57 PV(PMT= $877.57, I/YR=10, N=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) 2 Objectives for ARMs Calculate loan payments, loan balance, and interest charges on adjustable rate mortgages Effective cost of borrowing or lenders effective yield Calculate FTLAPR of an ARM Understanding the risks of both lender and borrower under an ARM ARMs and Lender Considerations Who should bear the interest rate risk on a mortgage? Market interest rates change daily, but 30 year FRM’s are common Fixed rate over life of the loan (FRMs): Lender bears the risk (presumably borrow pays a premium to escape this risk) ARMs – borrower bears some interest rate risk Unanticipated inflation – primary source of interest rate risk Uncertainty about all risk premiums (prepayment) ARMs: An Overview The interest rate charged on the note is indexed to other market interest rates The loan payment is adjusted at specified periods. The interest rate may vary with a shorter periodicity than the payments (e.g. COFI type loans) ARMs do not eliminate all interest rate risks The longer the adjustment period the greater the interest rate risk to the lender ARMs: Mechanics The borrower is charged an index based interest rate plus a spread – e.g. LIBOR plus 2.25% May be rounded to the nearest 1/8% Often limits on the amount the interest rate may adjust Often limits on the amount the payment may change Some 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 Indexes Over Time 0 2 4 6 8 10 12 14 16 18 Ja n-8 2 Ja n-8 4 Ja n-8 6 Ja n-8 8 Ja n-9 0 Ja n-9 2 Ja n-9 4 Ja n-9 6 Ja n-9 8 Ja n-0 0 Ja n-0 2 Ja n-0 4 Ja n-0 6 COFI 1 Year Treasury 30yrFixed 5 Ex. 6.2: ARM example #2 You are seeking a loan for your $250,000 house and have determined that you would like to choose an ARM because you expect to keep the house for just 3 years. Assume you make a 20% down payment and pay 2 points. What are your CF’s and the yield to lender? What do you pay each year in interest? Initial rate 3.5% Annual adjustments – Tbill + 2.75% (rounded to 1/8%) Max change of 2% per year interest rate Max interest of 5% above initial rate Index, now at 4.21, then changes annually to: 3.67, 6.23, 8.33 Ex 6.3: ARM example #3 You are seeking a loan for your $250,000 house and have determined that you would like to choose an ARM because you expect to keep the house for just 3 years. Assume you make a 20% down payment and pay 1 points. What are your CF’s and the yield to lender? What do you pay each year in interest? Initial rate 3.75% Annual adjustments – Tbill + 2.75% (rounded to 1/8%) Max payment change of 7.5% per year (negative amortization allowed) Max interest of rate 6% above initial rate Index, now at 4.21, then changes annually to: 3.67, 6.23, 8.33 FTLAPR for ARM’s The FTLAPR is computed assuming the index does not change, and may be rounded to the closest ¼% Example 6.4: A 15-year ARM with 3 points ($100,000 note amount) is offered with an initial interest rate of 3% based on the 1 year Treasury Index that is currently at 5.82. The margin is 275 bp. Annual interest rate cap is 2%, with a 6% lifetime ceiling (increase). What is the FTLAPR? Price Level Adjusted Mortgage When inflation is high, interest rates on either FRM’s or ARM’s will be high to compensate the lenders In real terms, the borrowers payment starts out very high, and then declines over time (payment tilt). This makes it hard to afford a very large loan. An alternative is to have a loan with a real interest rate, with a payment that is increased with inflation. The loan balance is also increase with inflation. This is much like TIPS 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 Example 6.5: PLAM example Consider a $100,000 loan offered at a 3% real rate of interest over 20 years. Payments and loan balance will be adjusted annually. Assuming inflation over the next three years is 18%, 11%, and 15% respectively, what are the loan payments, and final payoff required at the end of year 3? Problems with PLAM Payments could increase at a faster rate than income Mortgage balance might increase 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) Rather than charging a high interest rate to recover the effect of inflation, lender accepts compensation for inflation via the increasing value of the property. This allows the lender to charge a lower interest rate If the lender needs to pay depositors a high interest rate to attract deposits, it may not be able to offer SAM type mortgages. Lenders may wait years before receiving compensation Lenders need to be concerned about how well property will be maintained Shared Appreciation Mortgage (SAM) Continued Appreciation in value of real estate depends on action of borrowers, such as maintenance Appreciation paid to a lender ruled a contingent interest 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 Example 6.6: SAM example You have a building currently valued at $1,200,000 for which you seek a $1,000,000 mortgage (30-year with 5 year balloon). You are offered a SAM at 5%, where you must also give the lender 45% of the appreciation after 5 years. For an 8% annual inflation rate for the building, and assuming you hold the building for 5 years, what are your cash flows on the loan. What is the yield to the lender? 7 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 Reverse Annuity Mortgage 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 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 RAM Can Be: A cash advance A line of credit A monthly annuity Some combination of above RAM Example Yr Beg. Bal. Pmt Interest End Bal. 1 0 30659 2759 33418 2 33418 30659 5767 69844 3 69844 30659 9045 109548 4 109548 30659 12619 152826 5 152826 30659 16514 199999 Borrow $200,000 at 9% for 5 years, Annual Pmts.