Todays Outline

Alternative mortgage: II
Adjustable rate mortgage (ARM)

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Topics
Time Value of
Money

Applied
decisions
Refinance, choice Securitized REF
markets

Alternative
mortgages Mortgage products
mechanism & calculation and environments in
Singapore

FRM basics

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Purposes
Understand how the characteristics of
various alternative mortgages solve the
problems of a fixed-rate mortgage

Understand payment mechanics of ARM

Understand risk of ARM

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Problems with FRM
Interest rate risk
Cost of funding (liability = deposit) may become higher
than the fixed revenue from mortgage loan (asset)

Affordability
When interest rate is high and volatile

Tilt
the real payment stream in the early years have to
make up for the loss in purchasing power in later years
(affordability under high inflation)
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Adjustable-Rate Mortgage (ARM)
Designed to solve interest rate risk problem

Allows the lender to adjust the contract interest

rate periodically to reflect changes in market
interest rates

Lenders shift some interest rate risk onto

borrowers

Initial rate is generally less than FRM rate

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ARM Variables
Teaser rate for the first period
Index (e.g. 1 yr T-bill, 5 yr T-bond, SIBOR, SOR)
Margin (additional fixed %)
Adjustment Period (e.g. 1yr, 3yr, 5yr, 7yr, 10yr)
Caps and Floors
(limits on the amount of adjustment)
Periodic (limit per period, e.g. 2% per year)
Lifetime (limit for the overall period, e.g. 6% life time)

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ARM contract rate & pay rate
Contract Rate : i = Index + Margin
(e.g., 1yr T-bill rate + 2%)

Pay rate:
The rate that determines actual payment of the
mortgage loan

Caps and floors, if any, affect the pay rate

Pay rate for the first period = teaser rate

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ARM contract rate & pay rate
Periodic cap
limits how much the interest rate can be increased
each subsequent time

Lifetime cap
sets a maximum amount by which the interest rate
can be increased (from the initial rate) as long as
you keep the loan

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 ARM contract rate & pay rate
Teaser Rate = 4.5%
No periodic cap/floor
No lifetime cap/floor

% from
Index Contract % from Pay
Year Margin previous
Rate Rate initial rate Rate
period
1 4% 2% 6%
2 5% 2%
3 7% 2%
4 5% 2%

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 ARM contract rate & pay rate
Teaser Rate = 4.5%
Periodic cap/floor = 2%
No lifetime cap/floor

% from
Index Contract % from Pay
Year Margin previous
Rate Rate initial rate Rate
period
1 4% 2% 6%
2 5% 2%
3 7% 2%
4 5% 2%

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 ARM contract rate & pay rate
Teaser Rate = 4.5%
Periodic cap/floor = 2%
Lifetime cap/floor = 5%

% from
Index Contract % from Pay
Year Margin previous
Rate Rate initial rate Rate
period
1 4% 2% 6%
2 5% 2%
3 7% 2%
4 8% 2%

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ARM example
Loan amount = $150,000
Index = 1 year TB yield (4% now)
Adjustment period: One year
Margin = 200 bp (1 basis point = 0.01%)
Maturity = 30 years
Caps and Floors: 2%/ year, 6% life time
Monthly payment
Teaser Rate = 4.5%

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ARM example
Index assumption

Year Index Yield

1 4%
2 4%
3 7%
4 5%

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ARM example

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ARM example
Calculate the effective borrowing cost
assuming that you will pay off the loan at the
end of the 4th year (pay off all the remaining
balance)

<Cash flow diagram>

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ARM example (Texas Instruments)
CF0
C01: F01:
C02: F02:
C03: F03:
C04: F04:
C05: F05:
IRR (monthly)=
IRR (annual) =
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IRR with ARM
With some financial calculators, we dont have a
frequency function

Then, we basically have to enter all the monthly

payments, even if some payments are same

CASIO --- X,,1: 150000, 2: -760, 3: -760

I wont let you do this in your exam

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Problems with ARM
More complex and difficult to understand for
borrowers
(CHARM)

Setting appropriate teaser rate is not easy

for lenders

Risk of default is greater with ARM than with

FMR
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FRM vs. ARM

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FRM vs. ARM

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Lets try some experiments!

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Example in Singapore (HW)
1-year Fixed, No lock-in, No cap/floor,
20 years fully amortized, monthly payment
1st year 1.18% Fixed
2nd year 12-month SIBOR + 1.00%
3rd year 12-month SIBOR + 1.25%
Thereafter 12-month SIBOR + 1.25%

Complete the table (and calculate the effective cost assuming you repay
the remaining balance at the end of the 4th year )

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For Week 4,
Do your homework assignment
Read [B&F] Ch. 6

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