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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 Fixed-Rate Mortgage @ 8% for 30 Years, Monthly Payments PMT = $100,000 ( MC8,30) = $733.76 Interest Rate Risk If the market rate immediately goes to 10%, the market value of this mortgage goes to: PV = $733.76 (PVAF10/12,360) = $83,613 Lender loses $16,387 Interest Rate Risk 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 (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 ARM Variables Index Margin Adjustment Period Interest Rate Caps – Periodic – Lifetime Convertibility Negative Amortization Teaser Rate Determining The Contract Rate Fully Indexed: Contract Rate (i) = Index + Margin In general, the contract rate in time n is the lower of in= Index + Margin or in = in-1 + Cap 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% ARM Payment In Year 1 Index0 = 5% Pmt1 = $100,000 (MC5,30) = $536.82 ARM Payment In Year 2 BalanceEOY1= 536.82 (PVAF5/12,348) = $98,525 Interest Rate for Year 2 IndexEOY1 = 6% i = 6 + 2.50 = 8.5% or i = 5 + 2 = 7% Payment2 = $98,525 (MC7,29) = $662.21 ARM Payment In Year 3 BalanceEOY2 = $662.21 (PVAF7/12,336) = $97,440 Interest Rate for Year 3 IndexEOY2 = 6.5% i = 6.5 + 2.5 = 9% or i = 7 + 2 = 9% Pmt3 = 97,440 (MC9,28) = $795.41 Simplifying Assumption Suppose Index3-30 = 6.5% This means that i3-30 = 9% since the contract rate in year 3 is fully indexed Thus Pmt3-30 = $795.41 BalEOY3 = $96,632 ARM Effective Cost for a Three-Year Holding Period $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% ARM Annual Percentage Rate (APR) $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% Interest-Only ARM Payment in the initial period is interest-only with no repayment of principal After the initial period the loan becomes fully amortizing Loan is designed to fully amortize over its stated term 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 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 (PVAFi/12,36) + 120,000 (PVFi/12,36) i = 4.72% Interest-Only ARM What is the payment for year 4? Pmt = 120,000 (MC6,27) Pmt = $748.78 Interest-Only ARM What is the balance of the loan at the EOY 4 of the 30-year term? BalEOY4 = 748.78 (PVAF6/12,312) = $118,165 Interest-Only ARM If the loan is repaid at the EOY4, what is the effective cost? 120,000 – 2,400 = 400 (PVAFi/12,36) + 748.78 (PVAFi/12,12) + 118,165 (PVFi/12,48) i = 5.0145% Option ARM Gives the borrower the flexibility of several payment options each month Includes a “minimum” payment, an interestonly payment, and a fully Amortizing payment Usually has a low introductory contract rate Minimum payment results in negative amortization Option ARM Minimum payment can result in “payment shock” when payment increases sharply Loan must be recast to fully amortizing every five or ten years Negative amortization maximum of 125% of original loan balance Loan payment increases to fully amortizing level Alt-A Loan Alternative Documentation Loan or “No Doc” Loan Borrower may not provide income verification or documentation of assets Loan approval based primarily on credit score In the mid-2000s, loans were popular with non owner-occupied housing investors Flexible Payment ARM Very low initial payment, expected to rise over time “Payment shock” with dramatic increase in payment Appeal is the very low initial payment designed to help offset affordability problem Contract rate adjusts monthly with maybe no limits on size of interest rate changes Graduated-Payment Mortgage (GPM) 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 (GPM) 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 PLAM Example Suppose you borrow $100,000 for 30 years, monthly payments. The current real rate is 6% with annual payment adjustments EOY 1 2 3 4-30 Inflation 4% -3% 2% 0% PLAM Payment in Year 1 Pmt = $100,000 ( MC6,30) = $599.55 PLAM Payment in Year 2 BalEOY1 = $98,772 (1.04) = $102,723 Pmt2 = $102,723 (MC6,29) = $623.53 PLAM Payment in Year 3 BalEOY2 = $101,367 (.97) = $98,326 Pmt3 = $98,326 (MC6,28) = $604.83 PLAM Payment in Year 4 BalEOY3 = $96,930 (1.02) = $98,868 Pmt4 = $98,868 (MC6,27) = $616.92 PLAM Payment in Years 5-30 BalEOY4 = $97,356 (1.00) = $97,356 Pmt5-30 = $97,356 (MC6,26) = $616.92 PLAM Effective Cost If Repaid at EOY3 $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% PLAM Effective Cost If Held To Maturity (APR) $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 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 Reverse Mortgage Typical Mortgage - Borrower receives a lump sum up front and repays in a series of payments Reverse Mortgage - Borrower receives a series of payments and repays in a lump sum at some future time Reverse Mortgage Typical Mortgage - “ Falling Debt, Rising Equity” Reverse Mortgage - “ Rising Debt, Falling Equity” Reverse Mortgage Loan advances are not taxable Designed for senior homeowners for little or no mortgage debt Social Security benefits are generally not affected Interest is deductible when paid Reverse Mortgage 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. 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) Mortgage Refinancing Factors that are known to the borrower or can be calculated from the existing mortgage contract: – Current – Current – Current – Current contract rate payment remaining term outstanding balance Mortgage Refinancing Assumptions that must be made by the borrower: – What will be the amount of the new loan? Payoff of the existing loan? Payoff of the existing loan plus financing costs of the new loan? Payoff of the existing loan plus financing costs of the new loan plus equity to be taken out? Mortgage Refinancing Assumptions that must be made by the borrower: – What will be the term of the new loan? Equal to the remaining term of the existing loan? Longer than the remaining term of the existing loan? Shorter than the remaining term of the existing loan? Mortgage Refinancing Assumptions that must be made by the borrower: – What will be the holding period of the financing? Equal to the term (maturity) of the mortgage? Shorter than the term (maturity) of the mortgage?