1. California Real Estate Finance Fesler & Brady 10th Edition
Chapter 4
Adjustable Rate and Other Alternative Mortgage Instruments

2. Objectives After completing this chapter, you should be able to:
Discuss why, under certain market conditions, the fixed rate mortgage is again popular with some lenders.
List and briefly describe the various types of alternative mortgage instruments.
Explain how negative amortization works.
Give reason why balloon mortgages are not favored by consumers.
Demonstrate how a reverse annuity mortgage may be helpful for some older homeowners.
Compare the differences between 15-year loans and biweekly loan payments, and the payments on a standard 30-year loan.

3. Outline Objectives and Rationale Adjustable Rate Mortgages (ARMs)
Hybrid Loan Options
Balloon Payment Fixed Rate Loans
Reverse Annuity Mortgage (RAM)
Miscellaneous Alternative Plans
Epilogue

4. Objectives and Rationale
Transfer risk from lender to borrower
Tailor loans to the borrower’s financial circumstances
As interest rates on deposits rise, so do interest rates on mortgages and vice versa
Avoids problem of “borrowing short and lending long”
Cal-Vet loan program has been using ARMs for nearly 90 years

5. Purpose of ARMs Qualify for larger loan Lower initial payments
Make principal reduction payments

6. Adjustable Rate Mortgages (ARMs) (Slide 1 of 3)
Principal and interest payments rise and fall with inflation
Lower initial interest rate (teasers)
Tied to an “index”
11th District Cost of funds
U.S. Treasury bills and securities
LIBOR (London Interbank Offered Rate)
Maintain a “margin” (difference between index and rate charged)
Rates change every month, quarter, six months or year
Caps (ceilings and floors on interest rates per change and for life of loan)
Can lead to negative amortization
Monthly payments cannot cover interest, so difference is added to principal (Until it exceeds 20%, in which case, loan must be recast)
Notice of payment adjustments
Prepayment Penalty
Assumability

7. Disclosure Requirements for Adjustable Rate Mortgages (ARMs) (Slide 2 of 3)
Index
Where found
Five year history
How interest and margin rates interact
How teaser rates can change
When rates can change and lead time
Negative amortization features
Maximum caps
Annual interest increase
Total for loan
All in Consumer Handbook on Adjustable Rate Mortgages by Federal Reserve and Federal Home Loan Bank Board

8. Adjustable Rate Mortgages (ARMs) (Slide 3 of 3)
Advantages
Lower initial interest rates
Easier qualifying
Initial costs are smaller
Ability to qualify for larger loan
Payments come down with index
Easier assumability upon resale
No prepayment penalties
Lower interest rates in early years
Ability to make principal reduction payments
Better investment
Disadvantages
Income may not rise with payments
Slow market lack of appreciation
Negative amortization
Borrower has risk of rising interest rates

9. Hybrid Loan Options Fixed to ARM Two-Step Mortgage ARM to Fixed
Low interest in beginning
Switch to fixed or ARM
ARM to Fixed
Charge for conversion
Must convert during “window period”

10. Balloon Payment Fixed Rate Loans
Balloon mortgage
Amortize over 30 years, but due in 5 or 7 years
Payment more than double the amount of a regular installment is a Balloon
Usually seller carry back loans during high interest periods
Not popular because of uncertainty of rollover to new loan
Points
Interest rates

11. Reverse Annuity Mortgage (RAM) (Slide 1 of 4)
Tap equity with no monthly repayments
Must be 62 or older
Must own free and clear or have low existing loan
Single family dwellings
FHA approved condos
1-4 unit apartment buildings
Manufactured homes on separate lots
Due and payable
Death
Sale

12. RAM programs (Slide 2 of 4)
Home Equity Conversion Mortgage
FHA limits apply
ARM loan
Tied to 1-year T-bills
Home Keeper Program
Fannie Mae limits apply
Tied to 1-month CD rates
Conventional Programs
Not backed by FHA or Fannie Mae
No limits

13. RAM payment options (Slide 3 of 4)
Term
Equal monthly payments for a fixed number of years
Tenure
Equal monthly payments for as long as borrower occupies home
Line of credit option
Funds drawn as needed up to max

14. RAM basics (Slide 4 of 4)
Borrower pays loan fees, closing costs and monthly servicing fee
Mortgage insurance premiums will be charged
Due and payable on death or sale or vacancy
Due and payable if vacated for > one year
All payments plus interest
But not more than value of home
If sale price higher than loan, heirs keep balance
Must attend education session
Funds received are tax free, because this is a loan which must be repaid

15. Miscellaneous Alternative Plans
Fifteen year mortgage
Save ¼ to ½% on interest
Biweekly loan payments (26 payments/year)
Pay off 1/3 faster

16. Epilogue
Borrower beware!

17. Questions and Comments?