Chapter 6

Chapter 6Chapter 6

Alternative Alternative Mortgage Mortgage

InstrumentsInstruments

Chapter 6 Chapter 6 Learning ObjectivesLearning Objectives

Understand alternative mortgage Understand alternative mortgage instrumentsinstruments

Understand how the characteristics Understand how the characteristics of various AMIs solve the problems of various AMIs solve the problems of a fixed-rate mortgageof a fixed-rate mortgage

Interest Rate RiskInterest Rate Risk

Mortgage Example: Mortgage Example:

$100,000 Fixed-Rate Mortgage @ 8% $100,000 Fixed-Rate Mortgage @ 8% for 30 Years, Monthly Paymentsfor 30 Years, Monthly Payments

PMT = $100,000 ( MCPMT = $100,000 ( MC8,308,30) = $733.76) = $733.76


If the market rate immediately goes to If the market rate immediately goes to 10%, the market value of this mortgage 10%, the market value of this mortgage goes to:goes to:

PV = $733.76 (PVAFPV = $733.76 (PVAF10/12,36010/12,360) = $83,613) = $83,613

Lender loses $16,387Lender loses $16,387


If the lender can adjust the contract If the lender can adjust the contract rate to the market rate (10%), the rate to the market rate (10%), the payment increases and the market payment increases and the market value of the loan stays constant:value of the loan stays constant:

Pmt = $100,000 (MCPmt = $100,000 (MC10,3010,30) = $877.57) = $877.57

PV = $877.57 (PVAFPV = $877.57 (PVAF10/12,36010/12,360) = ) = $100,000$100,000

Alternative Mortgage Alternative Mortgage InstrumentsInstruments

Adjustable-Rate Mortgage (ARM)Adjustable-Rate Mortgage (ARM) Graduated-Payment Mortgage (GPM)Graduated-Payment Mortgage (GPM) Price-Level Adjusted Mortgage (PLAM)Price-Level Adjusted Mortgage (PLAM) Shared Appreciation Mortgage (SAM)Shared Appreciation Mortgage (SAM) Reverse Annuity Mortgage (RAM)Reverse Annuity Mortgage (RAM) Pledged-Account Mortgage or Flexible Pledged-Account Mortgage or Flexible

Loan Insurance Program (FLIP)Loan Insurance Program (FLIP)

Adjustable-Rate Adjustable-Rate Mortgage (ARM)Mortgage (ARM)

Designed to solve interest rate risk Designed to solve interest rate risk problemproblem

Allows the lender to adjust the contract Allows the lender to adjust the contract interest rate periodically to reflect interest rate periodically to reflect changes in market interest rates. This changes in market interest rates. This change in the rate is generally reflected change in the rate is generally reflected by a change in the monthly paymentby a change in the monthly payment

Provisions to limit rate changesProvisions to limit rate changes Initial rate is generally less than FRM rateInitial rate is generally less than FRM rate

ARM VariablesARM Variables IndexIndex MarginMargin Adjustment PeriodAdjustment Period Interest Rate CapsInterest Rate Caps

– Periodic Periodic – LifetimeLifetime

ConvertibilityConvertibility Negative AmortizationNegative Amortization Teaser RateTeaser Rate

Determining The Determining The Contract RateContract Rate

Fully Indexed:Fully Indexed:

Contract Rate (i) = Index + MarginContract Rate (i) = Index + Margin In general, the contract rate in time In general, the contract rate in time

n is the lower ofn is the lower ofiinn= Index + Margin = Index + Margin

oror

iin n = i= in-1n-1 + Cap + Cap

ARM ExampleARM Example Loan Amount = $100,000Loan Amount = $100,000 Index = 1-Year TB YieldIndex = 1-Year TB Yield One Year AdjustableOne Year Adjustable Margin = 2.50Margin = 2.50 Term = 30 yearsTerm = 30 years 2/6 Interest Rate Caps2/6 Interest Rate Caps Monthly PaymentsMonthly Payments Teaser Rate = 5%Teaser Rate = 5%

ARM Payment In Year 1ARM Payment In Year 1

IndexIndex0 0 = 5%= 5%

PmtPmt1 1 = $100,000 (MC= $100,000 (MC5,305,30) = ) = $536.82$536.82


BalanceBalanceEOY1EOY1= 536.82 (PVAF= 536.82 (PVAF5/12,3485/12,348) = ) = $98,525$98,525

Interest Rate for Year 2Interest Rate for Year 2

IndexIndexEOY1 EOY1 = 6%= 6%

i = 6 + 2.50 = 8.5% i = 6 + 2.50 = 8.5%

oror

i = 5 + 2 = 7%i = 5 + 2 = 7% PaymentPayment2 2 = $98,525 (MC= $98,525 (MC7,297,29) = $662.21) = $662.21


BalanceBalanceEOY2 EOY2 = $662.21 (PVAF= $662.21 (PVAF7/12,3367/12,336) = ) = $97,440$97,440

Interest Rate for Year 3Interest Rate for Year 3 IndexIndexEOY2 EOY2 = 6.5%= 6.5%

i = 6.5 + 2.5 = 9%i = 6.5 + 2.5 = 9%

oror

i = 7 + 2 = 9%i = 7 + 2 = 9% PmtPmt3 3 = 97,440 (MC= 97,440 (MC9,289,28) = $795.41) = $795.41

Simplifying AssumptionSimplifying Assumption

Suppose IndexSuppose Index3-30 3-30 = 6.5%= 6.5%

This means that iThis means that i3-30 3-30 = 9% since the = 9% since the contract rate in year 3 is fully indexedcontract rate in year 3 is fully indexed

Thus PmtThus Pmt3-30 3-30 = $795.41= $795.41

BalBalEOY3 EOY3 = $96,632= $96,632

ARM Effective Cost for a ARM Effective Cost for a Three-Year Holding Three-Year Holding

PeriodPeriod

$100,000 = 536.82 (PVAF$100,000 = 536.82 (PVAFi/12,12i/12,12) )

+ 662.21 (PVAF+ 662.21 (PVAFi/12,12i/12,12) (PVF) (PVFi/12,12i/12,12))


+ 96,632 (PVF+ 96,632 (PVFi/12,36i/12,36))

i = 6.89%i = 6.89%

ARM Annual ARM Annual Percentage Rate (APR)Percentage Rate (APR)

$100,000 = 536.82 (PVAF$100,000 = 536.82 (PVAFi/12,12i/12,12))

+662.21 (PVAF+662.21 (PVAFi/12,12i/12,12) ) (PVF(PVFi/12,12i/12,12))

+795.41 (PVAF+795.41 (PVAFi/12,336i/12,336) ) (PVF(PVFi/12,24i/12,24))

i = 8.40%i = 8.40%

Interest-Only ARMInterest-Only ARM

Payment in the initial period is interest-Payment in the initial period is interest-only with no repayment of principalonly with no repayment of principal

After the initial period the loan becomes After the initial period the loan becomes fully amortizingfully amortizing

Loan is designed to fully amortize over Loan is designed to fully amortize over its stated term its stated term

A 3/1 Interest-Only ARM is interest-only A 3/1 Interest-Only ARM is interest-only for the first three years and then for the first three years and then becomes a fully amortizing one-year becomes a fully amortizing one-year ARMARM


Suppose you take a 3/1 interest-Suppose you take a 3/1 interest-only ARM for $120,000, monthly only ARM for $120,000, monthly payments, 30-year term. The initial payments, 30-year term. The initial contract rate is 4.00% and the contract rate is 4.00% and the contract rate for year 4 is 6.00%. contract rate for year 4 is 6.00%. The lender charges two discount The lender charges two discount points.points.


What is the monthly payment for What is the monthly payment for the interest-only period?the interest-only period?

$120,000 (.04/12) = $400.00$120,000 (.04/12) = $400.00


What is the effective cost of the What is the effective cost of the loan if it is repaid at the EOY3?loan if it is repaid at the EOY3?

120,000 – 2,400 = 400 (PVAF120,000 – 2,400 = 400 (PVAFi/12,36i/12,36) ) + 120,000 + 120,000

(PVF(PVFi/12,36i/12,36))

i = 4.72%i = 4.72%


What is the payment for year 4?What is the payment for year 4?

Pmt = 120,000 (MCPmt = 120,000 (MC6,276,27))

Pmt = $748.78Pmt = $748.78


What is the balance of the loan at What is the balance of the loan at the EOY 4 of the 30-year term?the EOY 4 of the 30-year term?

BalBalEOY4EOY4 = 748.78 (PVAF = 748.78 (PVAF6/12,3126/12,312))

= $118,165= $118,165


If the loan is repaid at the EOY4, what If the loan is repaid at the EOY4, what is the effective cost?is the effective cost?

120,000 – 2,400 = 400 (PVAF120,000 – 2,400 = 400 (PVAF i/12,36i/12,36) )

+ 748.78 (PVAF+ 748.78 (PVAFi/12,12i/12,12) )

+ 118,165 (PVF+ 118,165 (PVFi/12,48i/12,48) )

i = 5.0145%i = 5.0145%

Option ARMOption ARM

Gives the borrower the flexibility of Gives the borrower the flexibility of several payment options each monthseveral payment options each month

Includes a “minimum” payment, an Includes a “minimum” payment, an interest-only payment, and a fully interest-only payment, and a fully Amortizing paymentAmortizing payment

Usually has a low introductory contract Usually has a low introductory contract raterate

Minimum payment results in negative Minimum payment results in negative amortizationamortization

Option ARMOption ARM

Minimum payment can result in Minimum payment can result in “payment shock” when payment “payment shock” when payment increases sharplyincreases sharply

Loan must be recast to fully amortizing Loan must be recast to fully amortizing every five or ten yearsevery five or ten years

Negative amortization maximum of Negative amortization maximum of 125% of original loan balance125% of original loan balance

Loan payment increases to fully Loan payment increases to fully amortizing levelamortizing level

Alt-A LoanAlt-A Loan

Alternative Documentation Loan or “No Alternative Documentation Loan or “No Doc” LoanDoc” Loan

Borrower may not provide income Borrower may not provide income verification or documentation of assetsverification or documentation of assets

Loan approval based primarily on credit Loan approval based primarily on credit scorescore

In the mid-2000s, loans were popular In the mid-2000s, loans were popular with non owner-occupied housing with non owner-occupied housing investorsinvestors

Flexible Payment ARMFlexible Payment ARM

Very low initial payment, expected to rise Very low initial payment, expected to rise over timeover time

““Payment shock” with dramatic increase Payment shock” with dramatic increase in paymentin payment

Appeal is the very low initial payment Appeal is the very low initial payment designed to help offset affordability designed to help offset affordability problemproblem

Contract rate adjusts monthly with maybe Contract rate adjusts monthly with maybe no limits on size of interest rate changesno limits on size of interest rate changes

Graduated-Payment Graduated-Payment Mortgage (GPM)Mortgage (GPM)

Tilt effect is when current payments Tilt effect is when current payments reflect future expected inflation. Current reflect future expected inflation. Current FRM payments reflect future expected FRM payments reflect future expected inflation rates. Mortgage payment inflation rates. Mortgage payment becomes a greater portion of the becomes a greater portion of the borrower’s income and may become borrower’s income and may become burdensomeburdensome

GPM is designed to offset the tilt effect by GPM is designed to offset the tilt effect by lowering the payments on an FRM in the lowering the payments on an FRM in the early periods and graduating them up early periods and graduating them up over timeover time

Graduated-Payment Graduated-Payment Mortgage (GPM)Mortgage (GPM)

After several years the payments level off After several years the payments level off for the remainder of the termfor the remainder of the term

GPMs generally experience negative GPMs generally experience negative amortization in the early yearsamortization in the early years

Historically, FHA has had popular GPM Historically, FHA has had popular GPM programsprograms

Eliminating tilt effect allows borrowers to Eliminating tilt effect allows borrowers to qualify for more fundsqualify for more funds

Biggest problem is negative amortization Biggest problem is negative amortization and effect on loan-to-value ratioand effect on loan-to-value ratio

Price-Level Adjusted Price-Level Adjusted Mortgage (PLAM)Mortgage (PLAM)

Solves tilt problem and interest rate risk Solves tilt problem and interest rate risk problem by separating the return to the problem by separating the return to the lender into two parts: the real rate of lender into two parts: the real rate of return and the inflation ratereturn and the inflation rate

The contract rate is the real rateThe contract rate is the real rate The loan balance is adjusted to reflect The loan balance is adjusted to reflect

changes in inflation on an ex-post basischanges in inflation on an ex-post basis Lower contract rate versus negative Lower contract rate versus negative

amortizationamortization

PLAM ExamplePLAM Example

EOYEOY11

22

33

4-304-30

InflationInflation4%4%

-3%-3%

2%2%

0%0%

Suppose you borrow $100,000 for 30 years, Suppose you borrow $100,000 for 30 years, monthly payments. The current real rate is monthly payments. The current real rate is 6% with annual payment adjustments6% with annual payment adjustments

PLAM Payment in Year PLAM Payment in Year 11

Pmt = $100,000 ( MCPmt = $100,000 ( MC6,306,30) = $599.55) = $599.55


BalBalEOY1 EOY1 = $98,772 (1.04) = = $98,772 (1.04) = $102,723$102,723

PmtPmt2 2 = $102,723 (MC= $102,723 (MC6,296,29) = ) = $623.53$623.53


BalBalEOY2 EOY2 = $101,367 (.97) = $98,326= $101,367 (.97) = $98,326

PmtPmt3 3 = $98,326 (MC= $98,326 (MC6,286,28) = $604.83) = $604.83


BalBalEOY3 EOY3 = $96,930 (1.02) = $98,868= $96,930 (1.02) = $98,868

PmtPmt4 4 = $98,868 (MC= $98,868 (MC6,276,27) = $616.92) = $616.92

PLAM Payment in Years 5-PLAM Payment in Years 5-3030

BalBalEOY4 EOY4 = $97,356 (1.00) = $97,356= $97,356 (1.00) = $97,356

PmtPmt5-30 5-30 = $97,356 (MC= $97,356 (MC6,266,26) = ) = $616.92$616.92

PLAM Effective Cost If PLAM Effective Cost If Repaid at EOY3Repaid at EOY3

$100,000 = 599.55 (PVAF$100,000 = 599.55 (PVAF i/12,12i/12,12))



+ 98,868 (PVF+ 98,868 (PVFi/12,36i/12,36))

i = 6.97%i = 6.97%

PLAM Effective Cost If PLAM Effective Cost If Held To Maturity (APR) Held To Maturity (APR)

$100,000 = 599.55 (PVAF$100,000 = 599.55 (PVAFi/12,12i/12,12))




i = 6.24%i = 6.24%

Problems with PLAMProblems with PLAM

Payments increase at a faster rate Payments increase at a faster rate than incomethan income

Mortgage balance increases at a Mortgage balance increases at a faster rate than price appreciationfaster rate than price appreciation

Adjustment to mortgage balance is Adjustment to mortgage balance is not tax deductible for borrowernot tax deductible for borrower

Adjustment to mortgage balance is Adjustment to mortgage balance is interest to lender and is taxed interest to lender and is taxed immediately though not receivedimmediately though not received

Shared Appreciation Shared Appreciation Mortgage (SAM)Mortgage (SAM)

Low initial contract rate with inflation Low initial contract rate with inflation premium collected later in a lump sum premium collected later in a lump sum based on house price appreciationbased on house price appreciation

Reduction in contract rate is related to Reduction in contract rate is related to share of appreciationshare of appreciation

Amount of appreciation is determined Amount of appreciation is determined when the house is sold or by appraisal when the house is sold or by appraisal on a predetermined future dateon a predetermined future date

Reverse MortgageReverse Mortgage

Typical Mortgage Typical Mortgage - Borrower receives - Borrower receives a lump sum up front and repays in a a lump sum up front and repays in a series of paymentsseries of payments

Reverse Mortgage Reverse Mortgage - Borrower receives - Borrower receives a series of payments and repays in a a series of payments and repays in a lump sum at some future timelump sum at some future time


Typical Mortgage Typical Mortgage - “ Falling Debt, - “ Falling Debt, Rising Equity”Rising Equity”

Reverse Mortgage Reverse Mortgage - “ Rising Debt, - “ Rising Debt, Falling Equity”Falling Equity”


Loan advances are not taxableLoan advances are not taxable Designed for senior homeowners Designed for senior homeowners

for little or no mortgage debtfor little or no mortgage debt Social Security benefits are Social Security benefits are

generally not affectedgenerally not affected Interest is deductible when paidInterest is deductible when paid


Reverse Mortgage Can Be:Reverse Mortgage Can Be:– A cash advance A cash advance – A line of creditA line of credit– A monthly annuityA monthly annuity– Some combination of aboveSome combination of above

Reverse Mortgage Reverse Mortgage ExampleExample

Yr Beg. Bal. Pmt Interest End Bal.1 0 30659 2759 334182 33418 30659 5767 698443 69844 30659 9045 1095484 109548 30659 12619 1528265 152826 30659 16514 199999

Borrow $200,000 at 9% for 5 years, Annual Pmts.

Pledged-Account Pledged-Account MortgageMortgage

Also called the Flexible Loan Insurance Also called the Flexible Loan Insurance Program (FLIP)Program (FLIP)

Combines a deposit with the lender with Combines a deposit with the lender with a fixed-rate loan to form a graduated-a fixed-rate loan to form a graduated-payment structurepayment structure

Deposit is pledged as collateral with the Deposit is pledged as collateral with the househouse

May result in lower payments for the May result in lower payments for the borrower and thus greater affordabilityborrower and thus greater affordability

Mortgage RefinancingMortgage Refinancing

Replaces an existing mortgage with a new Replaces an existing mortgage with a new mortgage without a property transactionmortgage without a property transaction

Borrowers will most often refinance when Borrowers will most often refinance when market rates are lowmarket rates are low

The refinancing decision compares the The refinancing decision compares the present value of the benefits (payment present value of the benefits (payment savings) to the present value of the costs savings) to the present value of the costs (prepayment penalty on existing loan and (prepayment penalty on existing loan and financing costs on new loan)financing costs on new loan)


Factors that are known to the Factors that are known to the borrower or can be calculated from borrower or can be calculated from the existing mortgage contract:the existing mortgage contract:– Current contract rateCurrent contract rate– Current paymentCurrent payment– Current remaining termCurrent remaining term– Current outstanding balanceCurrent outstanding balance


Assumptions that must be made by Assumptions that must be made by the borrower:the borrower:– What will be the amount of the new What will be the amount of the new

loan?loan? Payoff of the existing loan?Payoff of the existing loan? Payoff of the existing loan plus financing Payoff of the existing loan plus financing

costs of the new loan?costs of the new loan? Payoff of the existing loan plus financing Payoff of the existing loan plus financing

costs of the new loan plus equity to be costs of the new loan plus equity to be taken out?taken out?


Assumptions that must be made by Assumptions that must be made by the borrower:the borrower:– What will be the term of the new loan?What will be the term of the new loan?

Equal to the remaining term of the Equal to the remaining term of the existing loan?existing loan?

Longer than the remaining term of the Longer than the remaining term of the existing loan?existing loan?

Shorter than the remaining term of the Shorter than the remaining term of the existing loan?existing loan?


Assumptions that must be made Assumptions that must be made by the borrower:by the borrower:– What will be the holding period of the What will be the holding period of the

financing?financing? Equal to the term (maturity) of the Equal to the term (maturity) of the

mortgage?mortgage? Shorter than the term (maturity) of the Shorter than the term (maturity) of the

mortgage?mortgage?

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Chapter 6