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# Mortgage Bank Real Estate Fin FIN 4713

UTSA

GPA 3.77

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This 7 page Class Notes was uploaded by Miss Candida Hoppe on Thursday October 29, 2015. The Class Notes belongs to FIN 4713 at University of Texas at San Antonio taught by Thomas Thomson in Fall. Since its upload, it has received 23 views. For similar materials see /class/231327/fin-4713-university-of-texas-at-san-antonio in Finance at University of Texas at San Antonio.

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Date Created: 10/29/15

Fin 4713 Chapter 6 Alternative Mortgage Instruments Interest Rate Risk I Mortgage Example I 100000 8 for 30 years monthly payments I PMTPV1000OO N36 IIYR8 73376 Chapter 6 Learning Objectives I Understand alternative mortgage instruments I Understand how the characteristics of various AMls solve the problems of a xedrate mortgage Interest Rate Risk I If the market rate goes to 10 the market value of this mortgage goes to assuming amortized over the full term u PVPMT 73376 YR10 N360 83613 I Lender loses 16387 Interest Rate Risk I If the lender could automatically adjust the contract rate to the market rate 10 the market value of the loan remains a PmtPV100000 IIYR10 N360 87757 1 PVPMT 87757 IIYR10 N360 100000 I PIedgedAccount Mortgage or Flexible Loan Alte m ative Mo rtgage In strume nts I AdjustableRate Mortgage ARM I GraduatedPayment Mortgage GPM I PriceLevel Adjusted Mortgage PLAM I Shared Appreciation Mortgage SAM I Reverse Annuity Mortgage RAM Insurance Program FLIP I Objectives for ARMS I Calculate loan payments loan balance and interest charges on adjustable rate I Effective cost of borrowing or lenders effective yield I Calculate FTLAPR of an ARM I Understanding the risks of both lender and borrower under an ARM I ARMS and Lender Considerations I Who should bearthe interest rate risk on a mortgage I Market interest rates change daily but 30 year on I Fixed rate over life of the loan FRMs Lender bears the risk presumably borrow pays a premium to escape this risk I ARMS borrower bears some interest rate risk I Unanticipated in ation primary source of interest rate risk I Uncertainty about all risk premiums prepayment l ARMS An Overview I The interest rate charged on the note is indexed to other market interest rates I The loan payment is adjusted at specified periods The interest rate may vary with a shorter periodicity than the payments eg COFI type loans I ARMs do not eliminate all interest rate risks I The longer the adjustment period the greater the interest rate risk to the lender l ARMS Mechanics I The borrower is charged an index based interest rate plus a spread eg LIBOR plus 2 25 I May be rounded to the nearest 18 I Often limits on the amountthe interest rate may adjust I Often limits on the amountthe payment may change I Some ARM Indexes I Interest rates on six month treasury bills I Interest rates on one yeartreasury bills I Interest rates on three yeartreasury bills I Interest rates on five year treasury bills I Weighted average cost of funds I National average of existing loans fixed rate I LIBOR ARM Indexes Over Time a a a w 3 99 9 95 3 9 96 9 3 9 3 3 65 9 9 3 35 3 38 From HSH September 10 2008 Latest ARM Inde ZIZES 1 year Treasury IBM 208 3 year Treasury GEM 246 5 year Treasury rerun 293 11th District CEIFI 2698 Momh LlBIZIFt HSH 31111 quoter HSH A5 5 01 ates htt l 39uIIulu anTiirideie ccrri Ann Indexes from httpmortgagex comgeneralmortgageindexes asp l ARM Characteristics I Initial interest rate sometimes called the start rate or the contract rate or interest a lflowerthan index value plus margin it is typically referred to as a teaser ratequot I Index stated in mortgage I Adjustment interval usually tied to the index n COFI varies monthly and rate changes each month though payment does not a 1 Year Treasury based changes each year a 3 Year Treasury based changes every 3 years IARM Characteristics Continued I Margin a constant spread or premium added to the index I Composite rate the index plus the margin some imes called the marke ra e I Margin typically depends on Index see hshcom u LIBOR plus 225 basis points a basis point is 1100 percent u tYearTreasuryplus 275 bp u t YearMTA 12 month moving TreasuryAverage plus 0 bp u COFI plus xx bp u Average composite rate within 10 bp tor past 3 years tor the three indexes hsh IARM Characteristics Continued I Common Limitations Caps and ceilings u Maximum increases allowed in interest rate at adjustment u Maximum interest rate allowed on loan a Maximum increase allowed in payment though this maximum may reset say every 5 years to deal with excess negative amortization of if the principal hits some trigger amount such as 110 125 ofthe original principal amount a May be minimum interest rates but less important if the loan is prepayable as the borrower may prepay to get a better rate I ARM Characteristics Continued I Negative Amortization also called positive accrual occurs when payments are limited but interest rates rise so that the payment is below the interest amount due I Floors maximum reductions in payments or interest rates I Assumability Discount points Prepayment Privilege etc are like any other mortgage l ARMs Other Considerations Continued I Short term indexes are riskierto borrowers than long term indexes I Shorter adjustment periods are riskier to borrowers I Maximum caps on interest rate adjustments favor the borrower I Borrowers should be careful of negative amortization I In theory sophisticated investors who buy ac ed securities should be able to bear interest rate risk than homeowners I ARMs Other Considerations I Both lenders and borrowers face uncertainty when choosing ARMs I Risk premium ARMs typically have higher default rates why I Interest rate risk is now shared by the borrower and lender amount depends on ARM terms I Ceteris paribus at time of origination the expected yie on an ARM should be less than on a FRM because the borrower is accepting some or all of the interest rate risk l ARM Variations I 31 51 etc Hybrid ARMS u The rate is fixed for the rst period and then is a 1 year adjustable ARM after that period I Interest Only Option ARMS i There is no required loan amortization though the payment adjusts as interest rates changes The borrower has the option to pay down the principal Four payment options may be specified I Minimum payment may have negative amortization I Interest only payment I Amortize over 30 year lifetime I Amortize over 15 year lifetime l Teaser Rates I Initial rates for ARMs are stated and are typically n the sum ofthe index plus margin I For loans with a strong teaser that is an initial rate much lower than the composite rate would be the day the loan was ori inated there will be a larg expected paymen increase on the adjustment date I Ifthe borrower was quali ed on the teaser rate he r she may no e able to make the new higher payments I Many subprime mortgages were of a 21 structure with a teaser and so borrowers cannot afford the higher payment leading to high default rates IEX 61 ARM example 1 I You are seeking a loan for your 250000 house and have determined that you would like to choose an ARM because you expect to keep the house for just 3 years Assume you make a 20 down payment and pay 3 points What are your CF s and the yield to lender What do you pay each year in interest a Initial rate 325 n Annual adjustments Tbill 225 rounded to 18 a No payment or interest rate ca s u Index now at421 then changes annually to 367 623 833 Ex 6 ARM example 2 I You are seeking a loan foryour250y000 house and have determined that you Would l ke to choose an ARM because you expect to keep the house for lust 3 years Assume you make a 20 dokn payment and pay 2 points What are yourCF s and the yield to tender What do you payeach yearin interest a lnitialrat235 u Annual adlustrnentsTbill 2 75 roundedto 03 u Max Lhange of peryear intere u Max interestof5 aboye intial rate a index MW at l 2t then Lhangesannuallyto 361623 aaa 2 Ex 6 ARM example 3 I You are seeking a loan foryour250000 house and have de ermined that you Would like to choose an ARM because you expect to keep the house for lust 3 years Assume you make a 20 dokn p yment and payt points What are your CF s and he yield to tender What do you pay each year in lfttEl ESt7 u lnitialrat2375 u AnnualadlustmentsTbill 75roundedtotl u Max payment Lhange of75 peryearnegatiye amortiza ion alloWe u Max interest ofrate 6 aboye initial rate a noWatth then Lhangesannuallyto 361623 FTLAPR for ARM s l The FTLAPR is computed assuming the index does not change and maybe rounded to the closest 14 I Example 64 A15 yearARM With 3 points 100000 note amount is offered With an initial interest rate ot3 based on the 1 year Treasury Index that is currently at 582 The margin is 275 bp Annual interest rate cap is 2 with a 6 lifetime ceiling increase What is the FTLAPR was AIL mm mam ERADKY m P ce Level Adjusted Mortgage I When inflation is high interest rates on either FRM s or ARM s Will be high to compensate the lenders I in real terms the borrowers payment starts out very high and then declines over time payment tilt This makes it hard to afford a very large loan I An alternative is to have a loan With a real interest rate With a paymentthat is increased With inflation The loan balance is also increase With inflation This is much like Tl PS PriceLevel Adjusted Mortgage PLAND I Solyestilt problem and interest rate risk problem by separating the return to the lender into tWo parts the real rate of retum and the inflation rate I The contract rate isthe real rate I The loan balance is adlusted to reflect changes in inflation on an expost basis I LoWer contract rate yersus negatye amortization I Example 65 PLAM example I Consider a 100000 loan offered at a 3 real rate of interest over 20 years Payments and loan balance will be adjusted annually Assuming inflation overthe next three years is 18 11 and 15 respectively what are the loan payments and final payoff required at the end of year 3 Problems with PLAM I Payments could increase at a faster rate than income I Mortgage balance might increase at a faster rate than price appreciation I Adjustment to mortgage balance is not tax deductible for borrower I Adjustment to mortgage balance is interest to lender and is taxed immediately though not received Shared Appreciation Mortgage 8 a h than charging a high interest rate to recover the effect of inflation lender accepts compensation for inflation via the increasing value of the property This allows the lender to charge a lower interest rate I If the lender needs to pay depositors a high interest rate to attract deposits it may not be able to offer SAM type mortgages Lenders may wait years before receiving compensation I Lenders need to be concerned about how well property will be maintained Shared Appreciation Mortgage SAM Continued I Appreciation in value of real estate depends on action of borrowers such as maintenance I Appreciation paid to a lender ruled a contingent interest Shared Appreciation Mortgage SAND I Low initial contract rate with inflation premium collected later in a lump sum based on house price appreciation I Reduction in contract rate is related to share of appreciation I Amount of appreciation is determined when the house is sold or by appraisal on a predetermined future date Example 66 SAM example I You have a building currently valued at 1200000 forwhich you seek a 1000000 mortgage 30year with 5 year balloon You are offered a SAM at 5 where you must also give the lender 45 of the appreciation after 5 years For an 8 annual inflation rate forthe building and assuming you hold the building for 5 years what are your cash flows on the loan What is the yield to the lender Graduated Payment Mortgage I 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 I 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 P ayment Mortgage I A er several years the payments level off for the remainder o e term I GPMs generally experience negative amortization in the early years Historically FHA has had popular GPM programs Eliminating tilt effect allows borrowers to qualify for re funds I Biggest problem is negative amortization and effect on loanto value ra io Reverse Annuity Mortgage RAM Characteristics I Typical Mortgage Borrower receives a lump sum upfront and repays in a series of payments I RAM Borrower receives a series of payments and repays in a lump sum at some future time RAM Characteristics I Typical Mortgage Falling Debt Rising quity I RAM Rising Debt Falling Equity in Designed for retired homeowners with little or no mortgage debt in Loan advances are not taxable in Social Security bene ts are generally not affected in Interest is deductible when actually paid RAM Characteristics I RAM Can Be a A cash advance a A line of credit u A monthly annuity in Some combination of above RAM Example Borrow 200000 2119 for 5 years Annual Pmts Yr Beg Bal Pmt Interest End Bal 1 0 30659 2759 3 418 2 33418 30659 5767 69844 3 69844 30659 9045 109548 4 109548 30659 12619 152826 5 152826 30659 16514 199999

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