California Real Estate Finance
Bond, McKenzie, Fesler & Boone
Ninth Edition
Chapter 4
Adjustable Rate and Other
Alternative Mortgage Instruments
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Objectives
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After completing this chapter, you should be able to:
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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.
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Outline
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Objectives and Rationale
Adjustable Rate Mortgages (ARMs)
Hybrid Loan Options
Balloon Payment Fixed Rate Loans
Reverse Annuity Mortgage (RAM)
Miscellaneous Alternative Plans
Epilogue
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Objectives and Rationale
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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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Purpose of ARMs
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Qualify for larger loan
Lower initial payments
Make principal reduction payments
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Adjustable Rate Mortgages
(ARMs) (Slide 1 of 3)
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Principal and interest payments rise and fall with inflation
Lower initial interest rate (teasers)
Tied to an “index”
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11th District Cost of funds
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U.S. Treasury bills and securities
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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)
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Can lead to negative amortization
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Monthly payments cannot cover interest, so difference is added to
principal
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Until it exceeds 20%, in which case, loan must be recast
Notice of payment adjustments
Prepayment Penalty
Assumability
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Disclosure Requirements for
Adjustable Rate Mortgages (ARMs)
(Slide 2 of 3)
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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
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Annual interest increase
Total for loan
All in Consumer Handbook on Adjustable Rate Mortgages
by Federal Reserve and Federal Home Loan Bank Board
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Adjustable Rate Mortgages
(ARMs) (Slide 3 of 3)
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Advantages
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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
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Disadvantages
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Income may not rise with
payments
Slow market lack of
appreciation
Negative amortization
Borrower has risk of rising
interest rates
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Hybrid Loan Options
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Fixed to ARM
Two-Step Mortgage
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Low interest in beginning
Switch to fixed or ARM
ARM to Fixed
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Charge for conversion
Must convert during “window period”
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Balloon Payment Fixed Rate
Loans
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Balloon mortgage
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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
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Points
Interest rates
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Reverse Annuity Mortgage
(RAM) (Slide 1 of 4)
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Tap equity with no monthly repayments
Must be 62 or older
Must own free and clear or have low existing loan
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Single family dwellings
FHA approved condos
1-4 unit apartment buildings
Manufactured homes on separate lots
Due and payable
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Death
Sale
© 2011 Cengage Learning created by Dr. Richard S. Savich.
RAM programs
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Home Equity Conversion Mortgage
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FHA limits apply
ARM loan
Tied to 1-year T-bills
Home Keeper Program
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(Slide 2 of 4)
Fannie Mae limits apply
ARM loan
Tied to 1-month CD rates
Conventional Programs
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Not backed by FHA or Fannie Mae
No limits
© 2011 Cengage Learning created by Dr. Richard S. Savich.
RAM payment options
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Term
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Equal monthly payments for a fixed number of years
Tenure
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(Slide 3 of 4)
Equal monthly payments for as long as borrower
occupies home
Line of credit option
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Funds drawn as needed up to max
© 2011 Cengage Learning created by Dr. Richard S. Savich.
RAM basics
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(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
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Miscellaneous Alternative
Plans
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Fifteen year mortgage
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Save ¼ to ½% on interest
Biweekly loan payments (26 payments/year)
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Pay off 1/3 faster
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Epilogue
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Borrower beware!
© 2011 Cengage Learning created by Dr. Richard S. Savich.
Questions and Comments?
© 2011 Cengage Learning created by Dr. Richard S. Savich.