Mortgage Loans: Adjustable and Floating Rate

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Questions and Answers

What is the main topic of Chapter 5?

Adjustable and floating rate mortgage loans (correct)

Fixed interest rate mortgages with various payment patterns

Borrowers' ability to meet mortgage payments

Evolution of mortgage loans over time

What is the purpose of the Price Level Adjusted Mortgage (PLAM)?

To reduce the risk of default

To reflect expectations of the real interest rate and risk premium

To reduce the mortgage loan balance over time

To avoid loss due to unanticipated inflation (correct)

What is the formula to calculate the mortgage interest rate in a PLAM?

i = r + p + f (correct)

i = p + f

i = r + p

i = r - p - f

What is a limitation of using the Consumer Price Index (CPI) in a PLAM?

It is not a perfect index for housing prices Signup and view all the answers

How do PLAM balances adjust?

With changes in inflation Signup and view all the answers

What is a potential problem with a PLAM if the borrower's income does not increase with inflation?

The borrower may be unable to repay the loan Signup and view all the answers

Why may fixed rate mortgages lose value?

If an unanticipated rise in inflation occurs Signup and view all the answers

What is a characteristic of fixed rate mortgages in terms of their popularity?

Their popularity ebbs and flows with the state of the market Signup and view all the answers

Which ARM is likely to be priced higher?

ARM A Signup and view all the answers

What is the common feature of ARM A and ARM B?

Both have a margin of 3 percent Signup and view all the answers

What limits the annual increase in payments for both ARMs?

10 percent Signup and view all the answers

What is the result of the lender assuming less interest rate risk in an Adjustable Rate Mortgage?

The lender will receive a lower rate of interest Signup and view all the answers

If a FRM is available at 11 percent and an ARM is priced at 8 percent, what does it imply about inflation and forward rates?

Inflation is expected to increase Signup and view all the answers

What is the composite rate in Adjustable Rate Mortgages composed of?

Index + margin Signup and view all the answers

What is the annual rate cap for the mortgage in Example 5-2?

7.5 percent Signup and view all the answers

What is the primary component of the index in Adjustable Rate Mortgages?

All of the above Signup and view all the answers

What is the starting interest rate for the mortgage in Example 5-2?

9 percent Signup and view all the answers

What is the impact of a longer adjustment interval on the lender's interest rate risk?

The lender's interest rate risk increases Signup and view all the answers

What is the primary function of the margin in Adjustable Rate Mortgages?

To add a premium to the index Signup and view all the answers

What is the primary determinant of yields in Adjustable Rate Mortgages?

All of the above Signup and view all the answers

What is the primary risk posed to the lender in Adjustable Rate Mortgages?

Default risk Signup and view all the answers

What is the impact of shifting interest rate risk to borrowers in Adjustable Rate Mortgages?

The risk of default increases for the lender Signup and view all the answers

Study Notes

Adjustable and Floating Rate Mortgage Loans

Variable Payment Patterns

Fixed Rate Mortgages
Adjustable or Floating Rate Mortgages
Price Level Adjusted Mortgages (PLAMs)

Price Level Adjusted Mortgages (PLAMs)

Loan balance is adjusted for inflation
New payment is computed using the adjusted balance
Designed to avoid loss due to unanticipated inflation

Fixed Rate and Price Level Adjusted Mortgage

Fixed Rate Mortgages can lose substantial value if inflation rises unexpectedly
PLAMs are designed to avoid this loss
Mortgage interest rate (i) = real interest rate (r) + risk premium (p) + expected inflation (f)

Price Level Adjusted Mortgage (PLAM) Limitations

CPI may not be a perfect index for housing prices
Borrower's income may not increase at CPI, leading to repayment issues

Basic Issues with Adjustable Rate Mortgages

Adjustable Rate Mortgages (ARMs) do not eliminate interest rate risk
Longer adjustment intervals increase interest rate risk for lenders

Adjustable Rate Mortgages (ARMs)

Composite Rate = Index + Margin
Index: interest rate that the lender does not control (e.g., Treasury securities, COFI, LIBOR)
Margin: premium added to the index

Adjustable Rate Mortgage Yield and Rates

Yield is a function of:
- Initial interest rate
- Index and margin
- Points charged
- Frequency of payment adjustments
- Caps or floors on interest rate, payments, or loan balances

Adjustable Rate Mortgage Yield and Risks

Default Risk: can the borrower afford new payments?
Pricing Risk: allocation of interest rate risk and impact on default risk

Key Risks

Interest rate risk: risk that interest rates will change during the loan
Default risk: risk that the borrower will not fulfill the loan agreement

Allocating Risk between Borrowers and Lenders

ARMs shift interest rate risk to borrowers, increasing default risk for lenders

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Description

This chapter explores the challenges of fixed interest rate mortgages and how lenders address these issues with adjustable or floating rate mortgages, including variable payment patterns and price level adjusted mortgages.