Adjustable Rate Mortgages Chapter 6 Most popular AMI designed to solve interest rate risk problem is the adjustable rate mortgage With Fixed Rate mortgages the lender bears all of the risk Basic concept behind the adjustable rate Mortgage is to allow the interest rate on the loan to move with the market rate o Reduces interest rate risk faced by the lender by shifting it to the borrower o Because they face less interest rate risk with ARMs lenders require a lower return o And because borrowers are accepting interest rate risk they require the loan to be priced accordingly with a lower contract Nearly all ARMs have a provision that limit the amount by which the rate can increase ARM s have o Lower initial interest rate than FRMs o A rate in some fashion tied to the market o Provision for limiting the amount by which the rate or payments can change If Lender agrees to a very strict limit on the periodic change in the interest rate he may require a higher initial rate than otherwise Alternatively he may keep the rate low but raise the amount of discount points The longer the time between adjustments the greater the interest rate risk assumed by the lender Index provides the market rate and provides the basis for adjustments to the interest rate on the ARM o In general the index must be 1 beyond manipulation by the lender 2 not excessively volatile 3 established index 4 acceptable by the borrower o Indexes 1 Year Treasury Bill 3 Year Treasury Bill Note Yield LIBOR COFI Margin the amount in basis points added to the index to arrive at the contract rate for the loan o Once stated margin cannot be changed o Thus changes in the contract rate on the ARM are a result of movements in the index not changes in the margin Two Types of Interest Rate Caps each date of adjustment o Periodic Adjustment Rate Cap places limit on how much the contract rate can change at o Life of Loan establishes a ceiling that the contract rate can never exceed If the initial rate is 6 and the lifetime cap is 6 the max contract rate over the life of the loan will be 12 Smaller the Adjustment Rate Cap the greater the interest rate risk exposure to the lender o A 2 6 means that periodic rate cannot exceed greater or less than 2 and the life time loan will be 12 6 6 Negative Amortization is an increase in the loan balance as a result of payments that are less than the full amount of the interest change o Negative amortization represents default risk Lenders usually place limit of 125 of the loan o Negative amortization can occur when the loan has a payment cap or when the interest rate is adjusted more frequently than the payment Some ARMs are written to be convertible to a FRM nominal conversion fees apply and the mortgager is generally converted at an interest rate slightly above market average Method to measure the investment performance of loans is the IRR In rising interest rate periods the effective cost will be greatest for ARMs that have uncapped allow frequent rate changes have large margins and do not have large initial period discounts Interest Only ARMs Payment for the initial period is only interest with no repayment of principal After the initial period the loan becomes fully amortized over the remaining terms 3 1 means interest only for first 3 years and one year adjustable for the next 27 years Option ARMs 30 year payment Gives the borrower the flexibility of making one of several payments each month Optional payments include a minimum payment an interest only payment and a fully amortizing Generally have a low introductory contract rate With minimum payment option the payment amount may not be enough to pay all of the interest that is being charged amortization o Unpaid interest will be added to the principal balance of the loan resulting in negative Interest only payment allows borrower to avoid deferred interest but there is no repayment of principal o Generally not allowed if less than the minimum payment Major risk of making minimum payment is payment shock resulting from a sharp increase in Option ARM would be most attractive to the borrower who expects to own the property for a short time and prefers flexibility in the monthly payment the payment Alt A Loans Borrower may not provide income verification or documentation of assets thus approval is based primarily on the borrower s credit score Used heavily during the late 2000 s crisis Flexible Payment ARMs will increase over time Allows borrowers to make very low mortgage payments initially with the expectation that these Major drawback is possibility of Payment Shock which is a dramatic increase in monthly payments Primary appeal is the very low payment in early periods Pricing ARMs Adjustment Cap If the introduction of a term such as a cap on the rate change causes the lender more interest rate risk this will lower the value of the ARM To compensate the lender will have to charge discount points or add basis points to the margin o If no interest rate volatility ARM priced at par because there is no interest rate risk o As size of cap increases so will the value of the ARM interest rate risk is reduced o Longer the adjustment period the lower the value of the ARM for any given rate cap Life of Loan with a zero lifetime cap the ARM is bound and has the same value as an FRM o As life of the loan increases the value increases an approaches par for very large caps Margin increase in the margin will raise the value of an ARM Interest Rate volatility if interest rates are expected to rise in the future value of ARM will rise relative to a fixed loan rate o When interest rates rise in fixed rate better for borrower worse for lender In exchanges for a tighter rate cap and less frequent adjustments lenders will require either added discount points or a larger margin In exchange for an initial period discount on the rate lenders will require an addition to the margin or discount points Expectations that interest rate will rise or become more volatile will lead lenders to charge greater discounts on fixed rate loans or strictly bound ARMs The rate of interest on an Arm is typically 1 to 3 percentage points lower than that of a FRM o Lenders accept a lower rate for shifting a portion of the interest rate risk to borrowers o The more risk they can shift to borrowers through loose rate caps and frequent adjustments periods the lower the rate relative to that on a fixed rate When yield curve is sloping upward lenders will offer larger discounts on ARMs and