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## Chapter 6

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**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**Interest Rate Risk**6-2 • 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**Interest Rate Risk**6-4 • 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**Inflation**4% -3% 2% 0% EOY 1 2 3 4-30 6-14 PLAM Example Borrow $100,000 for 30 years, monthly payments. Current Real Rate = 6% with Annual Payment Adjustments**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**6-20**F. 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%**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%**6-22**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**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**6-26**RAM Characteristics • RAM Can Be: • A cash advance • A line of credit • A monthly annuity • Some combination of above**RAM Example**6-27 Borrow $200,000 at 9% for 5 years, Annual Pmts.**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)