© 2011 Cengage Learning created by Dr. Richard S. Savich.

California Real Estate FinanceBond, McKenzie, Fesler & Boone

Ninth Edition

Chapter 4Adjustable Rate and Other

Alternative Mortgage Instruments

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Objectives After completing this chapter, you should be able

to: Discuss why, under certain market conditions, the fixed

rate mortgage is again popular with some lenders. List and briefly describe the various types of alternative

mortgage instruments. Explain how negative amortization works. Give reason why balloon mortgages are not favored by

consumers. Demonstrate how a reverse annuity mortgage may be

helpful for some older homeowners. Compare the differences between 15-year loans and

biweekly loan payments, and the payments on a standard 30-year loan.

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Outline

Objectives and Rationale Adjustable Rate Mortgages (ARMs) Hybrid Loan Options Balloon Payment Fixed Rate Loans Reverse Annuity Mortgage (RAM) Miscellaneous Alternative Plans Epilogue

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Objectives and Rationale Transfer risk from lender to borrower Tailor loans to the borrower’s financial

circumstances As interest rates on deposits rise, so do

interest rates on mortgages and vice versa Avoids problem of “borrowing short and

lending long” Cal-Vet loan program has been using ARMs

for nearly 90 years

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Purpose of ARMs Qualify for larger loan Lower initial payments Make principal reduction payments

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Adjustable Rate Mortgages (ARMs) (Slide 1 of 3)

Principal and interest payments rise and fall with inflation Lower initial interest rate (teasers) Tied to an “index”

11th District Cost of funds U.S. Treasury bills and securities LIBOR (London Interbank Offered Rate)

Maintain a “margin” (difference between index and rate charged) Rates change every month, quarter, six months or year Caps (ceilings and floors on interest rates per change and for life of

loan) Can lead to negative amortization

Monthly payments cannot cover interest, so difference is added to principal

Until it exceeds 20%, in which case, loan must be recast Notice of payment adjustments Prepayment Penalty Assumability

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Disclosure Requirements for Adjustable Rate Mortgages (ARMs) (Slide 2 of 3)

Index Where found Five year history How interest and margin rates interact How teaser rates can change When rates can change and lead time Negative amortization features Maximum caps

Annual interest increase Total for loan

All in Consumer Handbook on Adjustable Rate Mortgages by Federal Reserve and Federal Home Loan Bank Board

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Adjustable Rate Mortgages (ARMs) (Slide 3 of 3)

Advantages Lower initial interest rates Easier qualifying Initial costs are smaller Ability to qualify for larger

loan Payments come down with

index Easier assumability upon

resale No prepayment penalties Lower interest rates in

early years Ability to make principal

reduction payments Better investment

Disadvantages Income may not rise with

payments Slow market lack of

appreciation Negative amortization Borrower has risk of rising

interest rates

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Hybrid Loan Options Fixed to ARM Two-Step Mortgage

Low interest in beginning Switch to fixed or ARM

ARM to Fixed Charge for conversion Must convert during “window period”

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Balloon Payment Fixed Rate Loans

Balloon mortgage Amortize over 30 years, but due in 5 or 7 years Payment more than double the amount of a

regular installment is a Balloon Usually seller carry back loans during high

interest periods Not popular because of uncertainty of

rollover to new loan Points Interest rates

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Reverse Annuity Mortgage (RAM) (Slide 1 of 4)

Tap equity with no monthly repayments Must be 62 or older Must own free and clear or have low existing

loan Single family dwellings FHA approved condos 1-4 unit apartment buildings Manufactured homes on separate lots

Due and payable Death Sale

© 2011 Cengage Learning created by Dr. Richard S. Savich.

RAM programs (Slide 2 of 4)

Home Equity Conversion Mortgage FHA limits apply ARM loan Tied to 1-year T-bills

Home Keeper Program Fannie Mae limits apply ARM loan Tied to 1-month CD rates

Conventional Programs Not backed by FHA or Fannie Mae No limits

© 2011 Cengage Learning created by Dr. Richard S. Savich.

RAM payment options (Slide 3 of 4)

Term Equal monthly payments for a fixed number of

years Tenure

Equal monthly payments for as long as borrower occupies home

Line of credit option Funds drawn as needed up to max

© 2011 Cengage Learning created by Dr. Richard S. Savich.

RAM basics (Slide 4 of 4)

Borrower pays loan fees, closing costs and monthly servicing fee

Mortgage insurance premiums will be charged Due and payable on death or sale or vacancy Due and payable if vacated for > one year All payments plus interest But not more than value of home If sale price higher than loan, heirs keep balance Must attend education session Funds received are tax free, because this is a loan which

must be repaid

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Miscellaneous Alternative Plans

Fifteen year mortgage Save ¼ to ½% on interest

Biweekly loan payments (26 payments/year) Pay off 1/3 faster

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Epilogue Borrower beware!

© 2011 Cengage Learning created by Dr. Richard S. Savich.

Questions and Comments?