Alternative Mortgage
Instruments

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

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

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

6-4
Interest Rate Risk

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
PV = $877.57 (PVAF
10/12,360
$100,000
) =

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)

Adjustable-Rate Mortgage
(ARM)




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
Provisions to limit rate changes
Initial rate is generally less than FRM rate

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

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

6-7
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%

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

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

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

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

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

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

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
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

Graduated-Payment Mortgage





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

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

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

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

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

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

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

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

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

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

6-22
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

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

6-23
RAM Characteristics

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

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

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

6-27 RAM Example
Borrow $200,000 at 9% for 5 years, Annual Pmts.
Yr Beg. Bal. Pmt
1 0 30659
2 33418 30659
Interest End Bal.
2759
5767
33418
69844
3 69844 30659 9045 109548
4 109548 30659 12619 152826
5 152826 30659 16514 199999

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

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)