22 Questions
What is the main topic of Chapter 5?
Adjustable and floating rate mortgage loans
What is the purpose of the Price Level Adjusted Mortgage (PLAM)?
To avoid loss due to unanticipated inflation
What is the formula to calculate the mortgage interest rate in a PLAM?
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
How do PLAM balances adjust?
With changes in inflation
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
Why may fixed rate mortgages lose value?
If an unanticipated rise in inflation occurs
What is a characteristic of fixed rate mortgages in terms of their popularity?
Their popularity ebbs and flows with the state of the market
Which ARM is likely to be priced higher?
ARM A
What is the common feature of ARM A and ARM B?
Both have a margin of 3 percent
What limits the annual increase in payments for both ARMs?
10 percent
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
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
What is the composite rate in Adjustable Rate Mortgages composed of?
Index + margin
What is the annual rate cap for the mortgage in Example 5-2?
7.5 percent
What is the primary component of the index in Adjustable Rate Mortgages?
All of the above
What is the starting interest rate for the mortgage in Example 5-2?
9 percent
What is the impact of a longer adjustment interval on the lender's interest rate risk?
The lender's interest rate risk increases
What is the primary function of the margin in Adjustable Rate Mortgages?
To add a premium to the index
What is the primary determinant of yields in Adjustable Rate Mortgages?
All of the above
What is the primary risk posed to the lender in Adjustable Rate Mortgages?
Default risk
What is the impact of shifting interest rate risk to borrowers in Adjustable Rate Mortgages?
The risk of default increases for the lender
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
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.
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