Adjustable-Rate Mortgages

1. Adjustable-Rate Mortgages • An adjustable-rate mortgage is a loan on which the periodic contractual interest rate can change over the life of the loan. • The rate is reset periodically to a fixed spread (called the margin) over a benchmark or reference rate. • Most common reference rate is short term Treasury rate as determined by current market conditions. • LIBOR • Others include calculated cost of funds or average mortgage rates

2. Why ARMs? • Interest Rate Risk • In the early 1980s, lenders were burned by holding long term fixed-rate mortgages while interest rates rose. • “Heads I Win; Tails You Lose” game • Unanticipated transfer of wealth from lenders (savers) to borrowers. • Lenders wanted to modify the mortgage contract to share the risk between lender and borrower more fairly.

3. Why ARMs? • “Tilt Problem” • When inflation is high, lenders need to build in expected inflation into the loan rate. • Nominal rate= real rate + expected inflation rate + risk adjustment • When inflation is high, this means the borrower must make high “real” payments at the start of the loan and low “real” payments at the end of the loan. • Makes it hard for borrowers to qualify for loans

4. Why ARMs? • Yield Curve: • In normal times, it costs more to borrow money at a fixed rate for a long time period than for a short time period. • Some borrowers only expect to need a loan for a period less than thirty years. • ARMs should be priced more like short term borrowings.

5. Defining an ARM • The periodic rate on an ARM is typically set as a fixed spread over an index or benchmark rate. • For example, the rate on a mortgage can be set at 2.75% over the one year Treasury rate. • To find the rate on the loan, we look up the one year Treasury rate (say 6.10%) and add 2.75% to it to get a rate of 8.85% . • The periodic rate is fixed at 8.85/12 for twelve months. At that point, it adjusts to 2.75% above the then current one year Treasury rate • If Treasury rate has fallen to 4.5%, the mortgage rate could fall to 7.0%

6. Defining an ARM • The spread over the index is called the loan’s margin. • The margin on an adjustable rate loan is an important factor in determining the true cost of an ARM. • Try to find the margin required by lenders in many loan advertisements.

7. Example of 1 Year ARM (No Caps)

8. Defining an ARM • In order to provide some protection for borrowers, ARMs provide limits on how much the loan rate and/or payment can change. • Lifetime limits or caps on how high the interest rate can rise • Life caps are often in the 5% to 6% range • Periodic rate caps limit how much the rate can change at any one time • Periodic caps are often in the 1% to 2% range

9. How Caps Work • When an ARM has rate caps, you can think of the adjustment process as having three steps: • Step 1: Calculate the rate as if there were no caps: Index+Margin • Step 2: See if the rate calculated in step 1 exceeds the lifetime cap on the loan. If it does, reduce the number from step 1 to the maximum allowable limit. • Step 3: See if the change from the current rate to the rate calculated in step 2 exceeds the periodic limit. If it does, set the rate equal to the old rate plus (or minus) the periodic limit.

10. Calculating the Rate on a Capped ARM Lifetime Cap=5% over original loan rate Periodic Cap=+/- 2%

11. Defining an ARM • Notice that although rates in the future are set by a formula of index + margin, subject to caps, the borrower and lender are free to set the initial rate at any level they want. • In this example, we have set it at the current index rate plus the margin. • Most lenders offer initial rates that are lower than index + margin • These lower rates are often called “Teaser Rates”

12. Teaser Rates • Teaser rates • lower the borrower’s initial monthly payment • lower the lifetime cap if it is specified as the initial rate plus a certain % • Build in expected increases in payments over time if rates do not change.

13. Effect of Teaser Rate on ARM Adjustment

14. ARM Amortization if Rates Stay Constant

15. ARM Amortization if Rates Rise

16. ARM Amortization if Rates Fall

17. Negative Amortization • What if instead of limiting how much the interest rate could increase, we limited how much the payment could increase. • For example, we could say the borrower’s payment will never increase by more than 15% in any one year. • If payment cap restricts the size of the monthly payment: • as long as payment > interest due, then (payment - interest) >0 loan amortizes • more slowly than normal • if payment < interest due in the month, then (payment-interest) < 0 and loan balance increases • Ending balance= beginning balance-(payment-Interest)

18. Negative Amortization from a 15% Payment Cap

19. Benefits of Negative Amortization • Lenders earn market rate at all times • Interest is accrued at the market rate even when the loan is negatively amortizing • Borrower can plan for the “worst case” in the next year’s payment increase • Rules of Thumb • 7.5% payment cap --- 1% interest rate cap • 15% payment cap --- 2% interest rate cap

20. Limits on Negative Amortization • Lenders generally impose limits on the amount of negative amortization. • Maximum % increase over original loan or linked to original house value • Payment caps removed near the end of the loan. • Experience has shown • Borrowers do not like negative amortization • They often voluntarily pay a larger payment • Default rates on neg. am ARMs is much higher • Neg. Am ARMs are not common in today’s market.

21. Risk Tradeoffs • ARMs without periodic interest rate caps or payment caps are best for reducing the lender’s interest rate risk. • Assuming no borrowers default from payment shock • ARMs with payment caps and no periodic interest rate caps reduce the default risk from payment shock but increase the risk that the lender will not collect the interest due. • ARMs with periodic interest rate caps increase the lender’s interest rate risk, but reduce the default risk • FRMs can be viewed as the limiting loan type as the rate caps get tighter

22. Types of ARMs • ARMs can be classified by how frequently they adjust the rate and the index they adjust to. • Periodicity • monthly, 6 months, annually, every three years, every five years • Fixed/Adjustable • Many ARMs have an initial period where the loan rate is fixed and then begin to adjust • 3/1, 5/1,10/1

23. Indexes • Some common indexes used for ARMs: • Treasury securities • 6 month, 1 year, 3 year, 5 year • Cost of Funds at Thrift Institutions • COFI (11th district) • National average rate on new mortgage loans • Fannie Mae or Freddie Mac purchase yields for new loans

24. When are ARMs Popular? • With a 250-275 bp margin and today’s 1 year Treasury rate, fully indexed cost of an ARM is 8.50%-8.75% • APRs are roughly 8.50%-9.0+% • See Hartford Courant Listing • Fixed rate loans (with no points) were offered in the range of 7.75 % with APR <8.0% • Most FRM APRs were somewhat less than 8%

25. When are ARMs popular? • ARMs are popular • a. When the yield curve is very steep so that loans priced off the short end of the yield curve appear to be less costly than fixed rate loans • b. When FRM rates are cyclically high • ARMs are more affordable • Borrower’s may expect to “roll down” to a lower fixed-rate after paying the low teaser rate for a couple of years. • Review the mortgage origination data from the first week and see if you can sort out when ARMs are popular and when they are not

26. Alphabet Soup • Many other mortgage types exist: • GPM • PLAM • GEM • SAM • Each loan type is designed to make a better, more marketable, loan for the borrower

27. GPM • A graduated payment mortgage is a fixed rate loan with a payment that starts out below the regular amortizing payment and is scheduled to increase each year • 5%-7.5% /year for roughly 5 years • Loan negatively amortizes in the first few years and then payment increases to the point that loan is fully amortized by the 30 year maturity

28. GEM • A Growing Equity mortgage is a fixed-rate loan where the borrower increases the payment over time with the extra payment reducing the principal and shortening the maturity of the loan

29. SAM • A shared appreciation mortgage is a fixed-rate mortgage where the borrower agrees to share the expected appreciation in house price over time with the lender in return for a lower interst rate on the loan

30. PLAM • A price level adjusted mortgage is effectively a variable rate loan. • Borrower agrees to pay a low “real” rate of interest excluding the inflation premium • At the end of each year, the balance of the loan is adjusted (usually increased) to reflect the inflation that occurred in a given year • The borrower’s payment is adjusted to amortize the new balance over the remaining term