Real Estate Finance Study Set 1

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Quiz 5 :

Adjustable and Floating Rate Mortgage Loans

Quiz 5 :

Adjustable and Floating Rate Mortgage Loans

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How does the price level adjusted mortgage (PLAM) address the problem of uncertainty in inflationary expectations What are some of the practical limitations in implementing a PLAM program
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Price level adjusted mortgage (PLAM) is a kind of mortgage where the mortgage payments get adjusted for inflations. The new mortgage payments after the adjustments are computed using the adjusted balance. In this kind of mortgages interest rate does not get varied while the principal changes. Usually the changes are reflected by index-CPI. For implementation of these changes the intervals are agreed upon by lender and borrower at frequent intervals.
As PLAM is a kind of remedy used to imbalance the problems for the savings institutions. In order to help reduce the risks associated with uncertainties of inflation and its impact over interest rates, it is suggestive for the lenders to originate mortgages at interest rates that which reflect the expectations of real interest rate in addition to a risk premium. This is needed to avoid the likelihood of loss that occurs due to getting defaulted upon a mortgage taken.
Limitations:
1. Indexing of loan balances to CPI would result in increase of loan balances rapidly than of property values. This would impact borrowers with a default of incentive
2. Another problem is with borrower income and mortgage payments, it is not necessary that the income of borrowers has a simultaneous increase along with the increase in inflation. This result in burden over households for payments of mortgage in short run.
3. Indexation price level is measured on the basis of historical data. Thus the index data is based upon the data collected in previous year but published in current year.

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An interest only ARM is made for $200,000 for 30 years. The start rate is 5 percent and the borrower will (1) make monthly interest only payments for 3 years. Payments thereafter must be sufficient to fully amortize the loan at maturity. a. If the borrower makes interest only payments for 3 years, what will payments be b. Assume that at the end of year 3, the reset rate is 6 percent. The borrower must now make payments so as to fully amortize the loan. What will payments be
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The term ARM refers to adjustable rate mortgage. As the name it suggests possible adjustments over mortgage, a mortgage loan with ARM modifies the interest rate upon mortgages periodically on the basis of inflation index. These changes would ultimately get reflected upon the lenders of borrowing in credit markets.
Solution (a) monthly payments in interest only payments for 3 years
The following table shows detailed computation of interest rates and amortizations along with BOY, EOY balances.
img img Therefore, from the above computation the monthly interest only payment in year 1 would be
img .
Solution (b) Monthly payments after 3 years when loan is fully amortized, reset rate is 6%
At the end of third year, the outstanding loan balance would be $200,000, reset interest rate is 6% annually, and remaining years are 27, and loan is fully amortized.
Following are the data inputs in spreadsheet to calculate monthly payments using PMT function:
img Following are the obtained results:
img Therefore, from the above computation the monthly payment for the rest periods would be
img

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An ARM is made for $150,000 for 30 years with the following terms: img img Compute the payments, loan balances, and yield for the ARM for the five-year period.
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The term ARM refers to adjustable rate mortgage. As the name itself suggests possible adjustments over mortgage, a mortgage loan with ARM modifies the interest rate upon mortgages periodically on the basis of inflation index. These changes would ultimately get reflected upon the lenders of borrowing in credit markets.
Interest rate caps are defined as the limits to which extent the interest rate or the monthly payments on mortgages can be changed at the each ending adjustment period or the whole tenure of the loan.
The ARM is made for $150,000 for a period of 30 years with maximum 5 % annual payment cap and allowance of negative amortizations. The margin is 2.00% and the initial Rate is 7.0%. Also consider that the payments will reset each year.
Here, uncapped rate is the periodic rate plus the margin:
img The calculation of the spreadsheet is given below:
img

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How do inflationary expectations influence interest rates on mortgage loans
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Which of the following two ARMs is likely to be priced higher, that is, offered with a higher initial interest rate ARM A has a margin of 3 percent and is tied to a three-year index with payments adjustable every two years; payments cannot increase by more than 10 percent from the preceding period; the term is 30 years and no assumption or points will be allowed. ARM B has a margin of 3 percent and is tied to a one-year index with payments to be adjusted each year; payments cannot increase by more than 10 percent from the preceding period; the term is 30 years and no assumption or points are allowed.
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A floating rate mortgage loan is made for $100,000 for a 30-year period at an initial rate of 12 percent interest. However, the borrower and lender have negotiated a monthly payment of $800. a. What will be the loan balance at the end of year 1 b. What if the interest rate increases to 13 percent at the end of year 1 How much interest will be accrued as negative amortization in year 1 if the payment remains at $800 Year 5
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If an ARM is priced with an initial interest rate of 8 percent and a margin of 2 percent (when the ARM index is also 8 percent at origination) and a fixed rate mortgage (FRM) with constant payment is available at 11 percent, what does this imply about inflation and the forward rates in the yield curve at the time of origination What is implied if a FRM were available at 10 percent 12 percent
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A basic ARM is made for $200,000 at an initial interest rate of 6 percent for 30 years with an Annual reset date. The borrower believes that the interest rate at the beginning of year ( BOY ) 2 will increase to 7 percent. a. Assuming that a fully amortizing loan is made, what will the monthly payments be during year 1 b. Based on ( a ) what will the loan balance be at the end of year ( EOY ) 1 c. Given that the interest rate is expected to be 7 percent at the beginning of year 2, what will the monthly payments be during year 2 d. What will be the loan balance at the EOY 2 e. What would be the monthly payments in year 1 if they are to be interest only
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A borrower has been analyzing different adjustable rate mortgage (ARM) alternatives for the purchase of a property. The borrower anticipates owning the property for five years. The lender first offers a $150,000, 30-year fully amortizing ARM with the following terms: img img Compute the payments, loan balances, and yield for the unrestricted ARM for the five-year period.
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Distinguish between the initial rate of interest and expected yield on an ARM. What is the general relationship between the two How do they generally reflect ARM terms
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What are forward rates of interest How are they determined What do they have to do with indexes used to adjust ARM payments
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A price level adjusted mortgage (PLAM) is made with the following terms: Amount = $95,000 Initial interest rate = 4 percent Term = 30 years Points = 6 percent Payments to be reset at the beginning of each year Assuming inflation is expected to increase at the rate of 6 percent per year for the next five years: a. Compute the payments at the beginning of each year ( BOY ). b. What is the loan balance at the end of the fifth year c. What is the yield to the lender on such a mortgage
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A 3/1 ARM is made for $150,000 at 7 percent with a 30-year maturity. a. Assuming that fixed payments are to be made monthly for three years and that the loan is fully amortizing, what will be the monthly payments What will be the loan balance after three years b. What would new payments be beginning in year 4 if the interest rate fell to 6 percent and the loan continued to be fully amortizing c. In ( a ) what would monthly payments be during year 1 if they were interest only What would payments be beginning in year 4 if interest rates fell to 6 percent and the loan became fully amortizing
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An ARM for $100,000 is made at a time when the expected start rate is 5 percent. The loan will be made with a teaser rate of 2 percent for the first year, after which the rate will be reset. The loan is fully amortizing, has a maturity of 25 years, and payments will be made monthly. a. What will be the payments during the first year b. Assuming that the reset rate is 6 percent at the beginning of year ( BOY ) 2, what will payments be c. By what percentage will monthly payments increase d. What if the reset date is three years after loan origination and the reset rate is 6 percent, what will loan payments be beginning in year 4 through year 25
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In the previous chapter, significant problems regarding the ability of borrowers to meet mortgage payments and the evolution of fixed interest rate mortgages with various payment patterns were discussed. Why didn't this evolution address problems faced by lenders What have lenders done in recent years to overcome these problems
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What is the difference between interest rate risk and default risk How do combinations of terms in ARMs affect the allocation of risk between borrowers and lenders
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Assume that a lender offers a 30-year, $150,000 adjustable rate mortgage (ARM) with the following terms: img Fully amortizing; however, negative amortization allowed if interest rate caps reached Based on estimated forward rates, the index to which the ARM is tied is forecasted as follows: img Compute the payments, loan balances, and yield for the ARM for the five-year period.
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List each of the main terms likely to be negotiated in an ARM. What does pricing an ARM using these terms mean
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Why do adjustable rate mortgages (ARMs) seem to be a more suitable alternative for mortgage lending than PLAMs
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MakeNu Mortgage Company is offering a new mortgage instrument called the Stable Mortgage. This mortgage is composed of both a fixed rate and an adjustable rate component. Mrs. Maria Perez is interested in financing a property, which costs $100,000, and is to be financed by Stable Home Mortgages (SHM) on the following terms: a. The SHM requires a 5 percent down payment, costs the borrower 2 discount points, and allows 75 percent of the mortgage to be fixed and 25 percent to be adjustable. The fixed portion of the loan is for 30 years at an annual interest rate of 10.5 percent. Having neither an interest rate nor payment cap, the adjustable portion is also for 30 years with the following terms: img img Calculate Mrs. Perez's total monthly payments and end-of-year loan balances for the first five years. Calculate the lender's yield, assuming Mrs. Perez repays the loan after five years. b. Repeat part ( a ) under the assumption that the initial interest rate is 9.5 percent and there is an annual interest rate cap of 1 percent.
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