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Questions and Answers
What is the main topic of Chapter 5?
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)?
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?
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?
What is a limitation of using the Consumer Price Index (CPI) in a PLAM?
How do PLAM balances adjust?
How do PLAM balances adjust?
What is a potential problem with a PLAM if the borrower's income does not increase with inflation?
What is a potential problem with a PLAM if the borrower's income does not increase with inflation?
Why may fixed rate mortgages lose value?
Why may fixed rate mortgages lose value?
What is a characteristic of fixed rate mortgages in terms of their popularity?
What is a characteristic of fixed rate mortgages in terms of their popularity?
Which ARM is likely to be priced higher?
Which ARM is likely to be priced higher?
What is the common feature of ARM A and ARM B?
What is the common feature of ARM A and ARM B?
What limits the annual increase in payments for both ARMs?
What limits the annual increase in payments for both ARMs?
What is the result of the lender assuming less interest rate risk in an Adjustable Rate Mortgage?
What is the result of the lender assuming less interest rate risk in an Adjustable Rate Mortgage?
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?
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?
What is the composite rate in Adjustable Rate Mortgages composed of?
What is the composite rate in Adjustable Rate Mortgages composed of?
What is the annual rate cap for the mortgage in Example 5-2?
What is the annual rate cap for the mortgage in Example 5-2?
What is the primary component of the index in Adjustable Rate Mortgages?
What is the primary component of the index in Adjustable Rate Mortgages?
What is the starting interest rate for the mortgage in Example 5-2?
What is the starting interest rate for the mortgage in Example 5-2?
What is the impact of a longer adjustment interval on the lender's interest rate risk?
What is the impact of a longer adjustment interval on the lender's interest rate risk?
What is the primary function of the margin in Adjustable Rate Mortgages?
What is the primary function of the margin in Adjustable Rate Mortgages?
What is the primary determinant of yields in Adjustable Rate Mortgages?
What is the primary determinant of yields in Adjustable Rate Mortgages?
What is the primary risk posed to the lender in Adjustable Rate Mortgages?
What is the primary risk posed to the lender in Adjustable Rate Mortgages?
What is the impact of shifting interest rate risk to borrowers in Adjustable Rate Mortgages?
What is the impact of shifting interest rate risk to borrowers in Adjustable Rate Mortgages?
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.
