Chapter 6 Alternative Mortgage Instruments © OnCourse Learning

Chapter 6 Learning Objectives  Understand alternative mortgage instruments (AMIs)  Understand how the standard mortgage terms are determined and how they are interrelated.  Understand how the characteristics of various AMIs solve the problems of a fixed-rate mortgage (FRM) © OnCourse Learning 2

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) © OnCourse Learning 3

Adjustable-Rate Mortgage (ARM)  Most popular AMI designed to solve the 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 © OnCourse Learning 4

ARM Variables  Index – CMT Index (e.g. 1-year T-bill); LIBOR; COFI; the 11 th District Cost of Funds Index  Margin – amount, in bps, added to the index to obtain the contract rate  Adjustment Period  Interest Rate Caps  Periodic (or rate)  Life-of-loan or life  First adjustment  Convertibility (to FRM)  Negative Amortization – increase in the loan balance from one period to the next  Teaser Rate – initial period discount © OnCourse Learning 5

Determining The Contract Rate  Fully Indexed: Contract Rate (i) = Index + Margin  In general, the contract rate in time n is the lower of i n = Index + Margin or i n = i n-1 + Cap © OnCourse Learning 6

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% © OnCourse Learning 7

ARM Payment In Year 1  Index 0 = 5%  Pmt 1 = $100,000 (MC 5/12,360 ) = $ © OnCourse Learning 8

ARM Payment In Year 2  Balance EOY1 = (PVAIF 5/12,348 ) = $98,525  Interest Rate for Year 2 Index EOY1 = 6% i = = 8.5% or i = = 7%  Payment 2 = $98,525 (MC 7/12,348 ) = $ © OnCourse Learning 9

ARM Payment In Year 3  Balance EOY2 = $ (PVAIF 7/12,336 ) = $97,440  Interest Rate for Year 3  Index EOY2 = 6.5% i = = 9% or i = = 9%  Pmt 3 = 97,440 (MC 9/12,336 ) = $ © OnCourse Learning 10

Simplifying Assumption  Suppose Index 3-30 = 6.5%  This means that i 3-30 = 9% since the contract rate in year 3 is fully indexed  Thus Pmt 3-30 = $  Bal EOY3 = $96,632 © OnCourse Learning 11

ARM Effective Cost for a Three-Year Holding Period  $100,000 = (PVAIF i/12,12 ) (PVAIF i/12,12 ) (PVIF i/12,12 ) (PVAIF i/12,12 ) (PVIF i/12,24 ) + 96,632 (PVIF i/12,36 ) i = 6.89%  The equation can be solved for i either by financial calculator or by an iterative process of trial and error  When using financial calculator, the cash flow mode is required since payments are different each year © OnCourse Learning 12

ARM Annual Percentage Rate (APR)  $100,000 = (PVAIF i/12,12 ) (PVAIF i/12,12 ) (PVIF i/12,12 ) (PVAIF i/12,336 ) (PVIF i/12,24 ) i = 8.40% © OnCourse Learning 13

Interest-Only ARM  Payment in the initial period is interest-only with no repayment of principal  After the initial period the loan becomes fully amortizing  Loan is designed to fully amortize over its stated term  A 3/1 Interest-Only ARM is interest-only for the first three years and then becomes a fully amortizing one- year ARM © OnCourse Learning 14

Interest-Only ARM  Suppose you take a 3/1 interest-only ARM for $120,000, monthly payments, 30-year term. The initial contract rate is 4.00% and the contract rate for year 4 is 6.00%. The lender charges two discount points. © OnCourse Learning 15

Interest-Only ARM  What is the monthly payment for the interest-only period? $120,000 (.04/12) = $ © OnCourse Learning 16

Interest-Only ARM  What is the effective cost of the loan if it is repaid at the EOY3? 120,000 – 2,400 = 400 (PVAIF i/12,36 ) + 120,000 (PVIF i/12,36 ) i = 4.72% © OnCourse Learning 17

Interest-Only ARM What is the payment for year 4? Pmt = 120,000 (MC 6/12,324 ) Pmt = $ © OnCourse Learning 18

Interest-Only ARM What is the balance of the loan at the EOY4 of the 30- year term? Bal EOY4 = (PVAIF 6/12,312 ) = $118,165 © OnCourse Learning 19

Interest-Only ARM  If the loan is repaid at the EOY4, what is the effective cost? 120,000 – 2,400 = 400 (PVAIF i/12,36 ) (PVAIF i/12,12 ) + 118,165 (PVIF i/12,48 ) i = % © OnCourse Learning 20

Option ARM  Gives the borrower the flexibility of several payment options each month  Includes a “minimum” payment, an interest-only payment, and a fully Amortizing payment  Usually has a low introductory contract rate  Minimum payment results in negative amortization © OnCourse Learning 21

Option ARM  Minimum payment can result in “payment shock” when payment increases sharply  Loan must be recast to fully amortizing every five or ten years  Negative amortization maximum of 125% of original loan balance  Loan payment increases to fully amortizing level © OnCourse Learning 22

Alt-A Loan  Alternative Documentation Loan or “No Doc” Loan  Borrower may not provide income verification or documentation of assets  Loan approval based primarily on credit score  In the mid-2000s, loans were popular with non owner-occupied housing investors © OnCourse Learning 23

Flexible Payment ARM  Very low initial payment, expected to rise over time  “Payment shock” with dramatic increase in payment  Appeal is the very low initial payment designed to help offset affordability problem  Contract rate adjusts monthly with maybe no limits on size of interest rate changes © OnCourse Learning 24

Graduated-Payment Mortgage (GPM)  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 © OnCourse Learning 25

Graduated-Payment Mortgage (GPM)  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 © OnCourse Learning 26

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 © OnCourse Learning 27

PLAM Example EOYInflation 14% 2-3% 32% 4-300% © OnCourse Learning 28 Suppose you borrow $100,000 for 30 years, monthly payments. The current real rate is 6% with annual payment adjustments

PLAM Example  Pmt in year 1 = $100,000 ( MC 6/12,360 ) = $  Pmt in year 2 Bal EOY1 = $98,772 (1.04) = $102,723 Pmt 2 = $102,723 (MC 6/12,348 ) = $  Pmt in year 3 Bal EOY2 = $101,367 (.97) = $98,326 Pmt 3 = $98,326 (MC 6/12,336 ) = $ © OnCourse Learning

PLAM Example (Cont.)  Pmt in year 4 Bal EOY3 = $96,930 (1.02) = $98,868 Pmt 4 = $98,868 (MC 6/12,324 ) = $  Pmt in year 5-30 Bal EOY4 = $97,356 (1.00) = $97,356 Pmt 5-30 = $97,356 (MC 6/12,312 ) = $ © OnCourse Learning 30

PLAM Effective Cost If Repaid at EOY3  $100,000 = (PVAIF i/12,12 ) (PVAIF i/12,12 ) (PVIF i/12,12 ) (PVAIF i/12,12 ) (PVIF i/12,24 ) + 98,868 (PVIF i/12,36 ) i = 6.97% © OnCourse Learning 31

PLAM Effective Cost If Held To Maturity (APR)  $100,000 = (PVAIF i/12,12 ) (PVAIF i/12,12 ) (PVIF i/12,12 ) (PVAIF i/12,12 ) (PVIF i/12,24 ) (PVAIF i/12,324 ) (PVIF i/12,36 ) i = 6.24% © OnCourse Learning 32

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 33 © OnCourse Learning

Dual Index Mortgage (DIM)  Uses more than one index for adjustment  Borrower’s rate tied to wage and salary index  Lender’s rate tied to interest rate index  If the borrower’s payment does not catch up with lender’s payment – balance at maturity  From lender’s standpoint similar to the ARM  From borrower’s standpoint not comparable to ARM  E.g. borrower’s initial payment low based on the a low interest rate, but rate due to lender higher – results in negative amortization 34 © OnCourse Learning

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 © OnCourse Learning 35

Reverse Mortgage  Typical Mortgage  Borrower receives a lump sum up front and repays in a series of payments  “Falling Debt, Rising Equity”  Reverse Mortgage  Borrower receives a series of payments and repays in a lump sum at some future time  “Rising Debt, Falling Equity” © OnCourse Learning 36

Reverse Mortgage  Loan advances are not taxable  Designed for senior homeowners for little or no mortgage debt  Social Security benefits are generally not affected  Interest is deductible when paid © OnCourse Learning 37

Reverse Mortgage  Reverse Mortgage Can Be:  A cash advance  A line of credit  A monthly annuity  Some combination of above 38 © OnCourse Learning

Reverse Mortgage Example © OnCourse Learning 39 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 © OnCourse Learning 40

Home Equity Loans  Typically revolving credit lines in which the borrower’s home serves as collateral  Have specific credit limits based on the borrower’s quality  Once the loan approved the borrower can draw any amount up to the limit at any point of time  Minimum payment required based on agreed amortization period  Generally, combined LTV of first and second mortgage should not exceed 80% of the house value 41 © OnCourse Learning

AMIs and Tax Deductibility of Interest Payments  With standard loan all interest payments are deducible  With some AMIs borrowers (as cash-basis taxpayers) may not use fully interest deductions  E.g. with GPM:  In initial years interest expense > payment  The borrower cannot deduct the excess of interest charge over the amount of payment.  The deduction is deferred until positive amortization begins 42 © OnCourse Learning

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) © OnCourse Learning 43

Mortgage Refinancing  Factors that are known to the borrower or can be calculated from the existing mortgage contract:  Current contract rate  Current payment  Current remaining term  Current outstanding balance © OnCourse Learning 44

Mortgage Refinancing  Assumptions that must be made by the borrower:  What will be the amount of the new loan? Payoff of the existing loan? Payoff of the existing loan plus financing costs of the new loan? Payoff of the existing loan plus financing costs of the new loan plus equity to be taken out? © OnCourse Learning 45

Mortgage Refinancing  Assumptions that must be made by the borrower:  What will be the term of the new loan? Equal to the remaining term of the existing loan? Longer than the remaining term of the existing loan? Shorter than the remaining term of the existing loan? © OnCourse Learning 46

Mortgage Refinancing  Assumptions that must be made by the borrower:  What will be the holding period of the financing? Equal to the term (maturity) of the mortgage? Shorter than the term (maturity) of the mortgage? 47 © OnCourse Learning

Refinancing Example  $100, year FRM at 10%, paid monthly, 3% prepayment penalty if repaid in the first 8 years  Consider refinancing in 5 yrs into 25-year FRM at 7.5%; 3% financing costs  Calculations:  Current payment: $  Payoff of existing loan = = Balance + Prepayment Penalty = $96, ,897 = $99,471  New loan payment: $  Monthly payment savings = $ = $  New loan financing costs = 3%*$99,471=$3,979  NPV of refinancing = $ (PVAIF7.5/12,300) - $3,979 = $15, © OnCourse Learning