CHAPTER 5 ADJUSTABLE RATE

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CHAPTER 5ADJUSTABLE RATE VARIABLE PAYMENT
MORTGAGES

• MORTGAGE LENDERS DILEMMA (1970s)
• RAPID INCREASES IN INFLATION (CAUSED MATURITY
  CAP)
• INCREASED COMPETITION FOR DEPOSITORS SAVINGS
• SOLUTIONS
• ALTERNATIVE MORTGAGE INVESTMENTS
• SALE OF FRM ORIGINATIONS
• DEREGULATION OF BANKING INDUSTRY

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ADJUSTABLE RATE MORTGAGE (ARM)

• A MORTGAGE CHARACTERIZED BY AN INTEREST RATE THAT
  CAN MOVE EITHER UP OR DOWN DEPENDING ON THE
  AGREED-TO INDEX.
• PURPOSE IS TO SHIFT INTEREST RATE RISK FROM
  LENDER TO BORROWER.

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ARM STRUCTURE

• ADJUSTMENT PERIOD - LENGTH OF TIME BEFORE THE
  INTEREST RATE AND PAYMENT CAN CHANGE (MOST COMMON
  PERIODS ARE 1, 3, 5 YEARS). GENERALLY SHORTER
  ADJUSTMENT INTERVALS MEAN LOWER INITIAL INTEREST
  RATE.
• INDEX - THE INDEX WILL DETERMINE THE INTEREST
  RATE AND THEREFORE THE PAYMENT. THE INDEX IS
  BEYOND THE CONTROL OF THE LENDER SIX-MONTH
  TREASURY BILL, ONE YEAR CONSTANT MATURITY
  TREASURY, THREE/FIVE YEAR TREASURY, FEDERAL HOME
  LOAN DISTRICT BANK COST OF FUNDS, ETC.

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• MARGIN - A CONSTANT PREMIUM ADDED TO INDEX RATE
  TO DETERMINE ARM INTEREST RATE (i.e. INDEX RATE
  AND MARGINARM INTEREST RATE OR COMPOSITE RATE)
• CAPS - LIMITATIONS ON INCREASES IN INTEREST
  RATES, PAYMENTS, MATURITY EXTENSIONS, AND
  NEGATIVE AMORTIZATION. PERIODIC CAPS SET LIMITS
  FROM ONE ADJUSTMENT PERIOD TO ANOTHER. LIFE-TIME
  CAPS LIMIT INCREASES OVER LIFE OF LOAN. FLOORS
  SET MAXIMUM REDUCTIONS

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• NEGATIVE AMORTIZATION - OCCURS WHEN PAYMENT CAPS
  ARE USED PAYMENT CANNOT INCREASE ENOUGH TO PAY
  ALL THE INTEREST DUE ON THE MORTGAGE, THUS THE
  OUTSTANDING BALANCE INCREASES.
• DISCOUNTS (TEASER RATES) - LOWERED INITIAL
  INTEREST RATE (AND THUS PAYMENT RATE) FROM THAT
  CALLED FOR BY ADDING TO TOGETHER THE
  INDEXMARGIN.
• SPREAD - DIFFERENCE BETWEEN RATES ARM FRM ARE
  INITIALLY OFFERED (USUALLY 200-300 BASIS POINTS)

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REGULATION Z (TRUTH IN-LENDING) REQUIRES
DISCLOSURE OF

• INTEREST RATE CEILING
• BOOKLET EXPLAINING ARMS
• 15 YEAR HISTORICAL EXAMPLE OF HOW RATES WOULD
  HAVE CHANGED
• WORST-CASE EXAMPLES

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PROBLEMS WITH ARMS

• MORE COMPLEX AND DIFFICULT TO UNDERSTAND
• BUDGET UNCERTAINTY FOR BORROWERS
• INCREASED DEFAULT RISK
• DONT NECESSARILY ELIMINATE INTEREST RATE RISK TO
  LENDER IF WRONG INDEX IS CHOSEN, MARGINS ARE TOO
  SMALL, CEILING TOO LOW, ETC.
• see text p. 145 (Exhibit 5-5)

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YIELD/RISK RELATIONSHIPS

• ARM EXPECTED YIELD SHOULD BE LESS THAN
  EXPECTED YIELD OF FRM DUE TO INTEREST RATE
  SHIFT.
• ARMS TIED TO SHORT-TERM INDEXES ARE RISKIER TO
  BORROWER - SHORT-TERM RATES ARE MORE VIOLATIBLE.
• SHORTER ADJUSTMENT PERIODS ARE RISKIER FOR
  BORROWER
• INTEREST RATE CAPS LOWER BORROWER INTEREST RATE
  RISK.
• PAYMENT CAPS THAT CAUSE NEGATIVE AMORTIZATION
  DONT REDUCE BORROWER INTEREST RATE RISK.

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BI-WEEKLY MORTGAGES

• Example Assume a 100,000 mortgage at 8 for 30
  years.
• Loan Product Periodic Payment Term
• 30-year, monthly pmt 733.77
  360 months
• Biweekly payment 366.89 272
  months
• Interest saved with biweekly mortgage 46,300.86

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CONVERTIBLE MORTGAGES - ARM THAT IS CONVERTIBLE
INTO FRM AT BORROWERS OPTION

• USUALLY CONVERSION ALLOWED BETWEEN 13th MONTH AND
  60th MONTH.
• CONVERSION FEE IS MUCH LOWER THAN COST TO
  REFINANCE.
• CONVERTIBLE ARMS USUALLY HAVE INTEREST RATES
  25-50 BASIS POINTS ABOVE NORMAL ARMS.

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SHARED APPRECIATION MORTGAGES

• LOWER INTEREST RATE FOR EQUITY INTEREST IN
  PROPERTY.