CHAPTER 5 ADJUSTABLE RATE & VARIABLE PAYMENT MORTGAGES

1. CHAPTER 5ADJUSTABLE RATE & VARIABLE PAYMENT MORTGAGES • MORTGAGE LENDER’S DILEMMA (1970’s) • RAPID INCREASES IN INFLATION (CAUSED “MATURITY CAP”) • INCREASED COMPETITION FOR DEPOSITORS’ SAVINGS • SOLUTIONS • ALTERNATIVE MORTGAGE INVESTMENTS • SALE OF FRM ORIGINATIONS • DEREGULATION OF BANKING INDUSTRY

2. ADJUSTABLE RATE MORTGAGE (ARM): • A MORTGAGE CHARACTERIZED BY AN INTEREST RATE THAT CAN MOVE EITHER UP OR DOWN DEPENDING ON THE AGREED-TO INDEX. • PURPOSE IS TO SHIFT INTEREST RATE RISK FROM LENDER TO BORROWER.

3. ARM STRUCTURE: • ADJUSTMENT PERIOD - LENGTH OF TIME BEFORE THE INTEREST RATE AND PAYMENT CAN CHANGE (MOST COMMON PERIODS ARE 1, 3, 5 YEARS). GENERALLY SHORTER ADJUSTMENT INTERVALS MEAN LOWER INITIAL INTEREST RATE. • INDEX - THE INDEX WILL DETERMINE THE INTEREST RATE AND THEREFORE THE PAYMENT. THE INDEX IS BEYOND THE CONTROL OF THE LENDER: SIX-MONTH TREASURY BILL, ONE YEAR CONSTANT MATURITY TREASURY, THREE/FIVE YEAR TREASURY, FEDERAL HOME LOAN DISTRICT BANK COST OF FUNDS, ETC.

4. MARGIN - A CONSTANT PREMIUM ADDED TO INDEX RATE TO DETERMINE ARM INTEREST RATE (i.e. INDEX RATE AND MARGIN=ARM INTEREST RATE OR COMPOSITE RATE) • CAPS - LIMITATIONS ON INCREASES IN INTEREST RATES, PAYMENTS, MATURITY EXTENSIONS, AND NEGATIVE AMORTIZATION. PERIODIC CAPS SET LIMITS FROM ONE ADJUSTMENT PERIOD TO ANOTHER. LIFE-TIME CAPS LIMIT INCREASES OVER LIFE OF LOAN. FLOORS SET MAXIMUM REDUCTIONS

5. NEGATIVE AMORTIZATION - OCCURS WHEN PAYMENT CAPS ARE USED + PAYMENT CANNOT INCREASE ENOUGH TO PAY ALL THE INTEREST DUE ON THE MORTGAGE, THUS THE OUTSTANDING BALANCE INCREASES. • DISCOUNTS (“TEASER RATES”) - LOWERED INITIAL INTEREST RATE (AND THUS PAYMENT RATE) FROM THAT CALLED FOR BY ADDING TO TOGETHER THE INDEX+MARGIN. • SPREAD - DIFFERENCE BETWEEN RATES ARM + FRM ARE INITIALLY OFFERED (USUALLY 200-300 BASIS POINTS)

6. REGULATION Z (TRUTH IN-LENDING) REQUIRES DISCLOSURE OF: • INTEREST RATE CEILING • BOOKLET EXPLAINING ARMS • 15 YEAR HISTORICAL EXAMPLE OF HOW RATES WOULD HAVE CHANGED • WORST-CASE EXAMPLES

7. PROBLEMS WITH ARMS: • MORE COMPLEX AND DIFFICULT TO UNDERSTAND • BUDGET UNCERTAINTY FOR BORROWERS • INCREASED DEFAULT RISK • DON’T NECESSARILY ELIMINATE INTEREST RATE RISK TO LENDER IF WRONG INDEX IS CHOSEN, MARGINS ARE TOO SMALL, CEILING TOO LOW, ETC. • see text p. 145 (Exhibit 5-5)

8. YIELD/RISK RELATIONSHIPS: • ARM “EXPECTED” YIELD SHOULD BE LESS THAN “EXPECTED” YIELD OF FRM DUE TO INTEREST RATE SHIFT. • ARMS TIED TO SHORT-TERM INDEXES ARE RISKIER TO BORROWER - SHORT-TERM RATES ARE MORE VIOLATIBLE. • SHORTER ADJUSTMENT PERIODS ARE RISKIER FOR BORROWER • INTEREST RATE CAPS LOWER BORROWER INTEREST RATE RISK. • PAYMENT CAPS THAT CAUSE NEGATIVE AMORTIZATION DON’T REDUCE BORROWER INTEREST RATE RISK.

9. BI-WEEKLY MORTGAGES: Example: Assume a $100,000 mortgage at 8% for 30 years. Loan Product Periodic Payment Term • 30-year, monthly pmt $733.77 360 months • Biweekly payment $366.89 272 months Interest saved with biweekly mortgage = $46,300.86

10. CONVERTIBLE MORTGAGES - ARM THAT IS CONVERTIBLE INTO FRM AT BORROWER’S OPTION • USUALLY CONVERSION ALLOWED BETWEEN 13th MONTH AND 60th MONTH. • CONVERSION FEE IS MUCH LOWER THAN COST TO REFINANCE. • CONVERTIBLE ARMS USUALLY HAVE INTEREST RATES 25-50 BASIS POINTS ABOVE NORMAL ARMS.

11. SHARED APPRECIATION MORTGAGES: • LOWER INTEREST RATE FOR EQUITY INTEREST IN PROPERTY.