Transcript Chapter 6
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)