ADJUSTABLE RATE AND VARIABLE PAYMENT MORTGAGES OBJECTIVES

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ADJUSTABLE RATE AND VARIABLE PAYMENT
MORTGAGESOBJECTIVES

• Calculate loan payments, loan balance, and
  interest charges on adjustable rate mortgages
• Effective cost of borrowing or lenders effective
  yield
• Calculate APR of an ARM
• Risks of both lender and borrower under an ARM

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ARMs and Lender Considerations

• Fixed rate over life of the loan (FRMs)
• Unanticipated inflation
• Uncertainty about all risk premiums (prepayment)
• Unexpected change in the interest rates
• Maturity gap

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ARMs An Overview

• Interest rates indexed to other market interest
  rates
• Terms are updated to current interest rate
  levels at the end of each adjustment period
• ARMs do not eliminate all interest rate risks
• Longer the adjustment period the greater the
  interest rate risk

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ARMs An Overview Continued

• As the lender assumes less interest rate risk,
  the borrower assumes more interest rate risk

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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

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ARM Characteristics

• Initial interest rate- sometimes called the start
  rate or the contract rate or interest. If lower
  than prevailing rates sometimes called a teaser
  rate of interest
• Index- stated in mortgages, as previously
  described
• Adjustment interval-usually six months or one year

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ARM Characteristics Continued

• Margin- a constant spread, or premium in addition
  to the index
• Composite rate- the index plus the margin,
  sometimes called the market rate
• Limitation on caps- maximum increases allowed in
  payments or interest rates between adjustment
  intervals

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ARM Characteristics Continued

• Negative Amortization- when additions to the
  outstanding loan balance are allowed
• Floors- maximum reductions in payments or
  interest rates
• Assumability
• Discount points
• Prepayment Privilege

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ARMs- Other Considerations

• Both lenders and borrowers face uncertainty when
  making ARMs
• Risk premium
• Interest rate risk
• Default risk
• At time of origination the expected yield on an
  ARM should be less than on a FRM

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ARMs- Other Considerations

• Short term indexes are riskier to borrowers than
  long term indexes
• Shorter adjustment periods are riskier to
  borrowers
• Maximum caps on interest rate adjustments favor
  the borrower
• Borrowers should be careful of negative
  amortization

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Shared Appreciation Mortgage (SAM)

• Lender is compensated for increases in inflation
• Transfers much of the risk of price level
  increases to the borrower
• Lenders may wait years before receiving
  compensation
• Lenders are concerned about how well home will be
  maintained

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Shared Appreciation Mortgage (SAM) Continued

• Appreciation in value of home depends on action
  of borrowers, such as maintenance
• Appreciation paid to a lender ruled a contingent
  interest