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Chapter 6 Alternative Mortgage Instruments

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Chapter 6 Learning Objectives Understand alternative mortgage instruments Understand alternative mortgage instruments Understand how the characteristics of various AMIs solve the problems of a fixed-rate mortgage Understand how the characteristics of various AMIs solve the problems of a fixed-rate mortgage 6-1

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Interest Rate Risk Mortgage Example: Mortgage Example: $100,000 @ 8% for 30 years, monthly payments $100,000 @ 8% for 30 years, monthly payments PMT = $100,000 ( MC 8,30 ) = $733.76 PMT = $100,000 ( MC 8,30 ) = $733.76 6-2

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Interest Rate Risk If the market rate goes to 10%, the market value of this mortgage goes to: If the market rate goes to 10%, the market value of this mortgage goes to: PV = $733.76 (PVAF 10/12,360 ) = $83,613 PV = $733.76 (PVAF 10/12,360 ) = $83,613 Lender loses $16,387 Lender loses $16,387 6-3

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Interest Rate Risk If the lender could automatically adjust the contract rate to the market rate (10%), the market value of the loan remains If the lender could automatically adjust the contract rate to the market rate (10%), the market value of the loan remains Pmt = $100,000 (MC 10,30 ) = $877.57 Pmt = $100,000 (MC 10,30 ) = $877.57 PV = $877.57 (PVAF 10/12,360 ) = $100,000 PV = $877.57 (PVAF 10/12,360 ) = $100,000 6-4

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Alternative Mortgage Instruments 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 Loan Insurance Program (FLIP) Pledged-Account Mortgage or Flexible Loan Insurance Program (FLIP)

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Adjustable-Rate Mortgage (ARM) Designed to solve interest rate risk problem 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 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 Provisions to limit rate changes Initial rate is generally less than FRM rate Initial rate is generally less than FRM rate

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ARM Variables Index Index Margin Margin Adjustment Period Adjustment Period Interest Rate Caps Interest Rate Caps Periodic Periodic Lifetime Lifetime Convertibility Convertibility Negative Amortization Negative Amortization Teaser Rate Teaser Rate 6-5

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Determining The Contract Rate Fully Indexed: Fully Indexed: Contract Rate = i = Index + Margin Contract Rate = i = Index + Margin In general, the contract rate is In general, the contract rate is i n = Index + Margin i n = Index + Margin or or i n = i n-1 + Cap i n = i n-1 + Cap whichever is lower whichever is lower 6-6

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ARM Example Loan Amount = $100,000 Loan Amount = $100,000 Index = 1 year TB yield Index = 1 year TB yield One year adjustable One year adjustable Margin = 2.50 Margin = 2.50 Term = 30 years Term = 30 years 2/6 Interest rate caps 2/6 Interest rate caps Monthly payments Monthly payments Teaser Rate = 5% Teaser Rate = 5% 6-7

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A. ARM Payment In Year One Index 0 = 5% Index 0 = 5% Pmt 1 = $100,000 (MC 5,30 ) = $536.82 Pmt 1 = $100,000 (MC 5,30 ) = $536.82 6-8

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B. ARM Payment In Year Two Balance EOY1 = 536.82 (PVAF 5/12,348 ) = $98,525 Balance EOY1 = 536.82 (PVAF 5/12,348 ) = $98,525 Interest Rate for Year Two Interest Rate for Year Two Index EOY1 = 6% Index EOY1 = 6% i = 6 + 2.50 = 8.5% i = 6 + 2.50 = 8.5% or or i = 5 + 2 = 7% i = 5 + 2 = 7% Payment 2 = $98,525 (MC 7,29 ) = $662.21 Payment 2 = $98,525 (MC 7,29 ) = $662.21 6-9

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C. ARM Pmt In Year 3 Balance EOY2 = $662.21 (PVAF 7/12,336 ) = $97,440 Balance EOY2 = $662.21 (PVAF 7/12,336 ) = $97,440 Index EOY2 = 6.5% Index EOY2 = 6.5% i = 6.5 + 2.5 = 9% i = 6.5 + 2.5 = 9% i = 7 + 2 = 9% i = 7 + 2 = 9% Pmt 3 = 97440 (MC 9,28 ) = $795.41 Pmt 3 = 97440 (MC 9,28 ) = $795.41 6-10

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Simplifying Assumption Suppose Index 3-30 = 6.5% Suppose Index 3-30 = 6.5% This means that i 3-30 = 9% This means that i 3-30 = 9% Thus Pmt 3-30 = $795.41 Thus Pmt 3-30 = $795.41 Bal EOY3 = $96,632 Bal EOY3 = $96,632 6-11

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ARM Effective Cost-Hold for 3 Years $100,000 = 536.82 (PVAF i/12,12 ) $100,000 = 536.82 (PVAF i/12,12 ) + 662.21 (PVAF i/12,12 ) (PVF i/12,12 ) + 662.21 (PVAF i/12,12 ) (PVF i/12,12 ) + 795.41 (PVAF i/12,12 ) (PVF i/12,24 ) + 795.41 (PVAF i/12,12 ) (PVF i/12,24 ) + 96,632 (PVF i/12,36 ) + 96,632 (PVF i/12,36 ) i = 6.89% i = 6.89% 6-12

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ARM Effective Cost-Hold to Maturity $100,000 = 536.82 (PVAF i/12,12 ) $100,000 = 536.82 (PVAF i/12,12 ) +662.21 (PVAF i/12,12 ) (PVF i/12,12 ) +662.21 (PVAF i/12,12 ) (PVF i/12,12 ) +795.41 (PVAF i/12,336 ) (PVF i/12,24 ) +795.41 (PVAF i/12,336 ) (PVF i/12,24 ) i = 8.40% i = 8.40% 6-13

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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 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 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

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Graduated-Payment Mortgage After several years the payments level off for the remainder of the term After several years the payments level off for the remainder of the term GPMs generally experience negative amortization in the early years GPMs generally experience negative amortization in the early years Historically, FHA has had popular GPM programs Historically, FHA has had popular GPM programs Eliminating tilt effect allows borrowers to qualify for more funds Eliminating tilt effect allows borrowers to qualify for more funds Biggest problem is negative amortization and effect on loan-to-value ratio Biggest problem is negative amortization and effect on loan-to-value ratio

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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 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 contract rate is the real rate The loan balance is adjusted to reflect changes in inflation on an ex-post basis The loan balance is adjusted to reflect changes in inflation on an ex-post basis Lower contract rate versus negative amortization Lower contract rate versus negative amortization

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PLAM Example Inflation Inflation 4% 4% -3% -3% 2% 2% 0% 0% EOY 1 2 3 4-30 6-14 Borrow $100,000 for 30 years, monthly payments. Current Real Rate = 6% with Annual Payment Adjustments

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A. PLAM Pmt in year 1 A. PLAM Pmt in year 1 Pmt = $100,000 ( MC 6,30 ) = $599.5 Pmt = $100,000 ( MC 6,30 ) = $599.5 6-15

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B. PLAM Pmt in year 2 Bal EOY1 = $98,772 (1.04) = $102,723 Bal EOY1 = $98,772 (1.04) = $102,723 Pmt 2 = $102,723 (MC 6,29 ) = $623.53 Pmt 2 = $102,723 (MC 6,29 ) = $623.53 6-16

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C. PLAM Pmt in year 3 Bal EOY2 = $101,367 (.97) = $98,326 Bal EOY2 = $101,367 (.97) = $98,326 Pmt 3 = $98,326 (MC 6,28 ) = $604.83 Pmt 3 = $98,326 (MC 6,28 ) = $604.83 6-17

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D. PLAM Pmt in year 4 Bal EOY3 = $96,930 (1.02) = $98,868 Bal EOY3 = $96,930 (1.02) = $98,868 Pmt 4 = $98,868 (MC 6,27 ) = $616.92 Pmt 4 = $98,868 (MC 6,27 ) = $616.92 6-18

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E. PLAM Pmt in years 5-30 Bal EOY4 = $97,356 (1.00) = $97,356 Bal EOY4 = $97,356 (1.00) = $97,356 Pmt 5-30 = $97,356 (MC 6,26 ) = $616.92 Pmt 5-30 = $97,356 (MC 6,26 ) = $616.92 6-19

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F. PLAM Effective Cost If Repaid at EOY3 $100,000 = 599.55 (PVAF i/12,12 ) $100,000 = 599.55 (PVAF i/12,12 ) + 623.53 (PVAF i/12,12 ) (PVF i/12,12 ) + 623.53 (PVAF i/12,12 ) (PVF i/12,12 ) + 604.83 (PVAF i/12,12 ) (PVF i/12,24 ) + 604.83 (PVAF i/12,12 ) (PVF i/12,24 ) + 98,868 (PVF i/12,36 ) + 98,868 (PVF i/12,36 ) i = 6.97% i = 6.97% 6-20

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G. PLAM Effective Cost If Held To Maturity $100,000 = 599.55 (PVAF i/12,12 ) $100,000 = 599.55 (PVAF i/12,12 ) + 623.53 (PVAF i/12,12 ) (PVF i/12,12 ) + 623.53 (PVAF i/12,12 ) (PVF i/12,12 ) + 604.83 (PVAF i/12,12 ) (PVF i/12,24 ) + 604.83 (PVAF i/12,12 ) (PVF i/12,24 ) + 616.92 (PVAF i/12,324 ) (PVF i/12,36 ) + 616.92 (PVAF i/12,324 ) (PVF i/12,36 ) i = 6.24% i = 6.24% 6-21

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Problems with PLAM Payments increase at a faster rate than income Payments increase at a faster rate than income Mortgage balance increases at a faster rate than price appreciation 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 not tax deductible for borrower Adjustment to mortgage balance is interest to lender and is taxed immediately though not received Adjustment to mortgage balance is interest to lender and is taxed immediately though not received 6-22

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Shared Appreciation Mortgage (SAM) Low initial contract rate with inflation premium collected later in a lump sum based on house price appreciation 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 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 Amount of appreciation is determined when the house is sold or by appraisal on a predetermined future date

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RAM Characteristics Typical Mortgage - Borrower receives a lump sum up front and repays in a series of payments 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 RAM - Borrower receives a series of payments and repays in a lump sum at some future time 6-23

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RAM Characteristics Typical Mortgage - “ Falling Debt, Rising Equity” Typical Mortgage - “ Falling Debt, Rising Equity” RAM - “ Rising Debt, Falling Equity” RAM - “ Rising Debt, Falling Equity” Designed for retired homeowners with little or no mortgage debt Designed for retired homeowners with little or no mortgage debt Loan advances are not taxable Loan advances are not taxable Social Security benefits are generally not affected Social Security benefits are generally not affected Interest is deductible when actually paid Interest is deductible when actually paid 6-25

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RAM Characteristics RAM Can Be: RAM Can Be: A cash advance A cash advance A line of credit A line of credit A monthly annuity A monthly annuity Some combination of above Some combination of above 6-26

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RAM Example Borrow $200,000 at 9% for 5 years, Annual Pmts. 6-27

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Pledged-Account Mortgage Also called the Flexible Loan Insurance Program (FLIP) 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 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 Deposit is pledged as collateral with the house May result in lower payments for the borrower and thus greater affordability May result in lower payments for the borrower and thus greater affordability

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Mortgage Refinancing Replaces an existing mortgage with a new mortgage without a property transaction Replaces an existing mortgage with a new mortgage without a property transaction Borrowers will most often refinance when market rates are low 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) 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)

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